Let me start by saying I’m not a tax professional or an attorney, but I am an experienced short sale facilitator. The answer below comes from my many years of experience in this area.
Tax liability as it relates to a short sale will largely depend on whether the real estate was your primary residence or an investment property.
Since the Internal Revenue Service (IRS) generally treats discharged debt as taxable income, the forgiven amount is usually included in the taxpayer’s gross income and could result in tax liability. However, at the time of this writing, the Qualified Principal Residence Indebtedness (QRPI) exclusion is still in effect, which allows some taxpayers to exclude the forgiven amount from their income for tax purposes. The QRPI exclusion was included in the Mortgage Debt Relief Act of 2007 and was added to the Internal Revenue Code. Although there have been extensions to the exclusion through the present (2020), there is no guarantee that this law will continue to extend year after year. Unless prohibited by state law, the mortgage lender will report the liability forgiveness to the IRS on Form 1099-C.
If you typically prepare your own taxes, I highly recommend that you hire a qualified Certified Public Accountant (CPA) to prepare your taxes that pertain to the year in which the short sale was completed. I need to stress the fact that not all accountants have the same experience or knowledge, so please interview them first to be sure that they are current on the latest laws regarding mortgage debt forgiveness.
The specific questions I would ask a CPA include the following:
- What is the status of the Mortgage Debt Relief Act of 2007?
- Is the Qualified Principal Residence Indebtedness exclusion still in effect? If so, do I qualify?
- Is IRS Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness) applicable to my situation?
- Are there any new or pending laws pertaining to mortgage debt forgiveness that I can benefit from?
- Will I have an actual tax liability as a result of a short sale?
In addition to speaking with a qualified CPA, you may also find it helpful to speak with a tax attorney