Many homeowners do not realize that they may be in store for a large tax bill from the IRS after the short sale of their home. Every situation is different and you should absolutely contact an accountant or tax advisor before conducting a short sale to determine your potential liability.
As an example assume you purchased your home for $400,000 in 2003. Since that time it has appreciated to $500,000 and you refinanced and now owe $450,000. You need to sell your home now but due to the bad market you can only get $400,000 for it. Your lender accepts a short sale since you owe them $450,000 but they are accepting only $400,000. The IRS considers the $50,000 that was "forgiven" by the lender as "debt relief" income.
Your lender will probably send you a 1099-C in the amount of $50,000 and the IRS will want you to pay taxes on that amount. What are the odds that you have that kind of money laying around after you just went through a short sale on your home? Be very careful regarding your tax obligations BEFORE you consider a short sale, deed-in-lieu-of-foreclosure or foreclosure.
The IRS will use your tax basis on your property to determine your tax obligations so you must be able to figure this amount out.
See our article on IRS Form 982. The form is used to request a "reduction in tax attributes" due to insolvency. This may allow you to
avoid having to pay taxes on the debt relief you experience with a short sale. Definitely worth talking to a tax attorney or accountant about!
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