In the event that a homeowner enters a short sale agreement with their mortgage lender to prevent their home from going into foreclosure, it rarely breaks even. There is usually a different between the amount owed on the house and the amount the home actually sells for. This difference is known as the canceled debt or deficiency. The effect is that the short sale adds to your taxable income at the end of the year, as the canceled debt is considered forgiven. Anytime you have a settlement, there is a chance you’ll have to pay taxes on the amount forgiven, but there are exceptions.

Canceled Debt from a Short Sale
The IRS considers the canceled debt as taxable income, but whether you will actually have to pay the taxes on it depends on the type of loan you have and the terms specified in the loan agreement. They are required to send you a 1099 form for your taxes, but that doesn’t always mean that you are responsible for paying the taxes on this. If you have a non-recourse loan, for example, you won’t be held responsible. A good attorney can also negotiate with the Bank to make sure you do not have responsibility for payment of taxes on the deficiency.

Three Ways to Avoid Paying Taxes on Canceled Debt
The first and easiest way to ensure that you won’t owe a big tax bill as a result of a short sale agreement is to check your original loan agreement. All government- backed home loans, including VA, FHA and USDA loans are non-recourse loans. They are exempt from paying taxes on the canceled debt.

The second way to avoid a large tax payment is to file bankruptcy. A bankruptcy completely wipes out the debt and removes the effect of having a larger taxable income due to the short sale. The only problem relates to timing. If the short sale took place long before the bankruptcy proceeding began, you may still be held responsible for paying taxes on the forgiven amount.

The third way to get out of paying taxes on the canceled debt is to show that you are insolvent. The IRS has what is known as the insolvency clause. If you can prove that your net worth is less than zero, you will likely qualify for this loophole. Basically, if your assets add up to less than your debts, you are viewed as uncollectable from a creditor’s standpoint.

The Mortgage Forgiveness Debt Relief Act
The Mortgage Forgiveness Debt Relief Act originated in 2007, but it has already been extended several times. It is currently active until the end of 2016, but may be extended again. Under this act, borrowers who have had a short sale to avoid foreclosure may be eligible for debt forgiveness, meaning that they would not have to pay taxes on the cancellation of debt. The plan is based on the decline of a home’s value or the personal hardship of the homeowner and was designed to create a stronger economy. The one caveat is that the money must be used to either buy or build a new home or remodel a home. It isn’t approved to pay down other debts.

Having a difference between the amount of money you owe on your home and the amount it sells for may initiate a 1099 from being sent from the lender at the end of the year. This doesn’t automatically mean that you have to pay taxes on this amount though. There are several options that help borrowers avoid increasing their taxable income as a result of a short sale. By doing your homework and seeing what resources are available, you may lessen the long term financial effect that a short sale can have.