A short sale can be an option to avoid foreclosure. It involves working with your lender to sell your home for less than what you owe on your mortgage. The lender agrees to forgive or forget about the difference if the sales price is less than your mortgage balance. But the IRS might see that difference as income. This could mean that it's taxable.

Sellers have negative equity when they owe more on their mortgages than their homes are worth. They're "upside down" or "under water" on their mortgage loan. Legislation went into effect at the start of 2007 to help these homeowners. There was some lapse in this statute, but the Consolidated Appropriations Act of 2019 extended it through 2025.1

Key Takeaways

  • Mortgage forgiveness became non-taxable under the terms of the Mortgage Forgiveness Debt Relief Act of 2007.
  • The Consolidated Appropriations Act extended this provision through 2025.
  • Mortgage forgiveness isn't taxable as long as the mortgage covers a principal residence.
  • The debt must have been incurred to buy, build, or improve the home.

The Mortgage Forgiveness Debt Relief Act of 2007

Suppose you sold your home in a lender-approved short sale. Your lender erased the unpaid portion of your mortgage. The tax code used to require that you must report any forgiven amounts on your Form 1040 tax return as income. The Mortgage Forgiveness Debt Relief Act of 2007 changed that.

The Act included a provision that allowed home sellers to exclude as much as $2 million of this type of canceled debt. You could exclude it from your taxable income if you met two rules. The mortgage had to be secured by your principal residence, the home where you lived most during the tax year. And you must have incurred the debt to "buy, build, or substantially improve" the home.2

Professional Help

You can contact a HUD-approved housing counselor to discuss your options if you're behind on your mortgage and you're unsure what to do about it.

Who Benefits From This Legislation?

The extended Mortgage Forgiveness Debt Relief Act doesn't apply to home equity loans or cash-out mortgage refinances unless the money was used to improve the home. It doesn't apply to debts on vacation homes, other second homes, or rental properties. It helps those whose debts were reduced or canceled due to loan modifications, foreclosures, deeds in lieu of foreclosure, and short sales.

The law applies to income from the discharge of qualified principal residence indebtedness (QPRI).3 This means that the mortgages were taken out by owners to buy, build, or improve their principal residences.

There's also a provision for debt reduced through mortgage restructuring, as well as for debt used to refinance QPRI. But the relief extends only up to the amount of the first mortgage's principal balance just before the refinancing.

Note

The law doesn't help homeowners who take advantage of a surge in real estate prices to do “cash-out” refinancing if they didn't use the funds to improve their primary homes.

Short Sale Tax Implications

Tax rules require debtors to report all forgiven debts on their Form 1040 tax returns, just as they would report income from salaries or wages, if they don't meet these rules. The IRS taxes forgiven debt at the same rate as ordinary income from other sources.

Note

Some other types of forgiven debt avoid taxation, such as debt that's discharged in bankruptcy or if you can prove that you were insolvent when the debt was waived.

The Bottom Line

Canceled debts on a short sale won't be counted as taxable income at the federal level through at least 2025, thanks to the extension of the Mortgage Forgiveness Tax Relief Act. But they're not just a federal tax issue. Check with your state to learn the rules that apply where you live and where your home is located. Taxation on canceled debt from a short sale does not apply in the state of California under most circumstances, due to California Code Civil Code 580e.4

The best approach is to work with a tax professional.