Do You Owe the IRS for the Difference After a Short Sale?

By Business & Finance Last updated Tuesday, June/04/2024

The Old Rules

Before 2007, if a short sale or foreclosure resulted in unpaid mortgage debt, the IRS classified that difference as income and taxed it accordingly. An unpaid debt, the thinking went, was tantamount to money in your pocket -- regardless of whether it was used to buy a house or take a trip. If you repaid the debt, then you netted nothing, so no tax had to be paid. If you didn't repay the debt, it was yours to keep. And pay taxes on. The only notable exceptions to this rule occurred when the mortgage was a non-recourse loan -- that is, a loan for which you were not personally liable and the lender's only legal recourse was to foreclose. In some states, such as California, a mortgage used to purchase a property (as opposed to one taken out in a refinance) is, by law, a non-recourse loan.

Signed by President Barak Obama in 2007, the Mortgage Forgiveness Debt Relief Act exempts up to $2 million in forgiven mortgage debt on your principal residence. If your home is foreclosed upon or sold through short sale, you do not owe taxes on the unpaid loan balance. The law is slated to expire at the end of 2012. Unless your loan is non-recourse or you have or will be filing for bankruptcy, mortgage debt arising from investment property is not exempted from taxation.

Unpaid mortgage debt may still be taxable at the state level. In California, the state Legislature passed an exemption on unpaid mortgage debt that is similar to the federal law in both duration and content. Check your state's tax law regarding unpaid mortgage debt.

To be forgiven the tax on unpaid mortgage debt is one thing. To be forgiven the debt itself is another. Some states, like California, require a lender that accepts a short sale to forgive the borrower the entire debt. Some states do not allow a lender to go after the borrower in any way other than a foreclosure. Others allow the lender to sue for the full amount of mortgage debt. If your state allows the lender to go after borrowers for the difference between the short sale proceeds and the loan balance, add a contingency clause to the short sale contract requiring the lender to forgive the loan with the short sale.