TAXATION OF SHORT SALES

What are the tax implications of a real estate short sale?
When a lender agrees to a short sale and sells a property for less than the outstanding mortgage debt, the amount of the debt that the lender writes off is treated as ordinary income. The amount of the debt or the ordinary income may or may not be subject to taxation depending on different circumstances and we recommend a tax consultation with a professional.
Under the Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648) signed by the President on December 20, 2007, IRS code §108(a)(1)(E), provides that a taxpayer will not be taxed upon cancellation of debt income if the following conditions are met:
•    The property sold in the short sale is the taxpayer's principal residence, as that term is used in IRC §121.
•    The cancellation of debt is Qualified Principal Residence Indebtedness** under IRC Section 163(h)(3)(B).
•    The indebtedness is discharged after January 1, 2007 and before January 1, 2010.
The definition of a Qualified Principal Residence Indebtedness is a loan secured by the residence used to acquire, construct or substantially improve the residence. The income relief provided is capped at $1,000,000 in the case of a married person filing a separate return and $2,000,000 for all others.
Any reduction of indebtedness excluded by IRC §108(a)(1)(E) will be applied to reduce the basis of the taxpayer's principal residence, but not below zero. This could result in a higher amount of capital gains tax owed by the taxpayer.
It has not been an issue in the media yet, but homeowners need to be aware that if the short sale is a result of equity or “Cash Out,” the owner could also be subject to capital gains tax when selling the property. This is the case if the Cash was used for anything other than home improvements and not for college, cars, or other types of debt purchases.