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Tax Implications & Consequences of a Short Sale or Foreclosure

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In the aftermath of the 2007 to 2009 Great Recession, millions of Americans faced the pain of foreclosure and many had to navigate the frustrating process of short sales to sell their homes.

Even after the economy rebounded, homeowners weren’t immune to foreclosures and short sales. In fact, according to data from a NeighborWorks America fact sheet, every three months, an average of 250,000 homes enter foreclosure.

Foreclosures and short sales each come with a long list of repercussions, but few people consider the tax implications — at least until it comes time to file their income tax return.

Short Sale vs. Foreclosure

Homeowners who can’t keep up with their mortgage payments generally have two options: a short sale or a foreclosure.

Short Sale

A short sale is a voluntary process in which a homeowner sells the home for an amount that’s less than they owe on the mortgage. For example, the homeowner may sell the home for $150,000, even though they owe $200,000 on the mortgage.

Before the sale can take place, the lender must sign off on the decision to short-sell the property. Typically, the lender requires documentation from the homeowner explaining why they can’t pay the mortgage and a short-sale is the best option.

Once the lender agrees to the short sale, the home goes on the market. Any offers made on the property go to the lender — not the homeowner — to accept, counter, or reject.

A short sale is usually a better option than foreclosure because it has less impact on the homeowner’s credit. According to Experian, a mortgage loan settled through a short sale typically results in a 120- to 130-point drop in the homeowner’s credit score, whereas a foreclosure generally causes a decline of 130 to 140 points.

That difference might not seem like much, but according to Fannie Mae, you can rebuild your credit — and possibly even get another mortgage — faster after a short sale. You’re eligible for a Fannie Mae-backed mortgage just two years after a short sale but must wait seven years after a foreclosure.


A foreclosure is a legal process in which a lender takes back a property from a borrower who has stopped paying their mortgage. The lender evicts the borrower and attempts to sell the home.

While the rules for foreclosures vary by state, a foreclosure can take place anywhere from three to six months after the homeowner misses a mortgage payment, assuming the homeowner hasn’t made up the missed payments or made arrangements with the lender to modify their payments.

If you know foreclosure is inevitable, you may be able to avoid the lengthy legal process with a deed-in-lieu of foreclosure. In this kind of arrangement, you agree to give your mortgage lender the deed to your home. While a deed-in-lieu is quicker and easier than a traditional foreclosure, the tax implications are the same.

Depending on the laws in the state where the property is located, in either a short sale or a foreclosure, the lender may require the homeowner to make up the difference between the selling price of the home and the mortgage balance. However, many lenders agree to forgive the debt, which is where the tax implications come in.

Taxable Forgiveness of Debt

Typically, the IRS considers forgiven debt a source of income. For example, say you owe $15,000 in credit card debt and negotiate with your credit card company to accept $5,000 and forgive the last $10,000. The credit card company sends you an IRS Form 1099-C  for cancellation of debt at the end of the year reporting that $10,000 as income.

They also send a copy to the IRS, so the IRS expects to see that $10,000 reported on your tax return. Depending on your tax bracket, the resulting tax bill could be substantial.

However, the IRS does provide some exceptions to the cancellation of debt income. One of those is the discharge of debt on a principal residence through the Mortgage Forgiveness Debt Relief Act.

History of the Mortgage Forgiveness Debt Relief Act

In late 2007, Congress passed the Mortgage Forgiveness Debt Relief Act to provide tax relief to the millions who were forced to settle their mortgage loans for less than the amount they owed.

The Mortgage Forgiveness Debt Relief Act of 2007 allowed taxpayers to exclude from income up to $2 million of forgiven debt ($1 million if married filing separately) on their principal residence due to mortgage restructuring, foreclosure, or short sale.

Initially, the act applied to debt forgiven in calendar years 2007 through 2012, although Congress extended it a few times. The most recent extension came at the end of 2020 with the Consolidated Appropriations Act (CAA).

Previously, mortgage forgiveness relief had been allowed to expire after 2020, but the CAA extended forgiveness for tax years 2021 through 2025. However, it limited the maximum excluded forgiven debt to $750,000.

How the Mortgage Forgiveness Debt Relief Act Works

While the act helps reduce your tax liability, it doesn’t cut down on the amount of paperwork you have to deal with.

When you settle a debt for less than you owe, your lender issues a Form 1099-C. This form reports the fair market value of your home just before the foreclosure and the amount of forgiven debt.

To get the tax relief, you must still report the cancellation of debt on your tax return. You report and calculate the tax consequences of debt forgiveness on Form 982.

You must report two potential tax consequences:

  1. Income from the cancellation or forgiveness of the debt
  2. Possible gain from the disposition of the home

To calculate the debt cancellation on Form 982, subtract the fair market value of the home (as reported on the 1099-C, Box 7) from the total amount of the debt just before the foreclosure. A number greater than zero represents debt forgiveness income and carries to Line 21 (other income) of Page 1 of your 1040 tax form.

To calculate the gain from the disposition of the home, subtract your adjusted basis in the home — what you paid for the home plus significant home improvements that increased the value — from the fair market value of the home at foreclosure (again, from 1099-C, Line 7).

If the value of the home at foreclosure is higher than your adjusted basis, you have a gain reportable on Form 1040, Schedule D for capital gains and losses.

But note that as with most elements of the tax code, there are exclusions and exceptions.

What Isn’t Covered

The IRS explanation uses the word “generally.” It’s possibly the single most loaded word appearing in IRS regulations. And this ambiguous escape clause shows up in their regulations quite frequently. In this case, it means that not all foreclosures and short sales are covered, so you need to know if the act can help you or not.

There are two notable exceptions to the act:

  1. The act doesn’t cover second homes and investment properties. If a lender forgives your debt on either of these property types, you must report it as income. The provisions of the act apply only to your principal residence.
  2. Perhaps more significantly, the act holds that you can only exclude the discharge of principal residence indebtedness. That’s debt used to buy, build, or substantially improve your principal residence or to refinance debt incurred for those purposes. Simply put, if you refinanced your home mortgage (just once or many times) and took out cash in excess of your original debt, you can’t exclude any forgiven debt from the cash-out portion of your refinance. You must report it as taxable income.

For example, let’s say you took out a $180,000 mortgage on a $200,000 home. Later, the value rose to $250,000, and you refinanced to get an extra $20,000 cash to pay off credit cards. The difference between the original mortgage ($180,000) and the new mortgage ($200,000) is $20,000. That $20,000 is considered taxable income after a foreclosure or short sale.

Similarly, home equity lines of credit and second mortgages you take after purchasing your home are also excluded. But if you use the proceeds to make major improvements to your home, then that money is protected.

Some good news: Even if you find yourself in one of the exceptions to the act, you can exclude up to $250,000 ($500,000 if married filing jointly) under the one-time exclusion of a gain on a primary residence.

Options if You Don’t Qualify

If you fall into one of these exceptions or if the IRS finds another reason their “generally” clause blocks you out, you can still find relief in other parts of the tax code.

  1. Bankruptcy. If your home and mortgage are included and discharged through bankruptcy, the forgiven debt is generally not taxable.
  2. Nonrecourse Loans. In several states, home loans are “nonrecourse,” which means your lender’s remedy for default is limited to the value of the property secured by your loan. The lender may not pursue your other assets to satisfy the debt. Forgiveness of a nonrecourse loan doesn’t represent taxable income to the borrower. Mortgages are nonrecourse in 12 states (Alaska, Arizona, California, Connecticut, Idaho, Minnesota, North Carolina, North Dakota, Oregon, Texas, Utah, and Washington state). But check with your attorney to see if there are any other provisions in your community.
  3. Insolvency. If your total liabilities exceed your total assets, then you’re technically “insolvent,” and forgiven debt may qualify under the insolvency exclusion. If you’re insolvent, the IRS doesn’t usually require you to include forgiven debts in your income. If you think you fall into this category, talk with your tax attorney. The substantiation requirements for this exclusion are considerable, and you need a pro to help you prepare the paperwork.

Final Word

Hopefully, a foreclosure or short sale is a once-in-a-lifetime situation. But if you’re facing the challenge of losing your home, you need to know what the tax consequences and implications are before they sneak up on you and cause more damage to your budget.

Understanding the Mortgage Forgiveness Debt Relief Act can help ease some of the burden or at least keep you from being surprised by your accountant or the IRS.

Complete information on mortgage debt cancellation is available in IRS Publication 4681. But you likely want to enlist the help of a qualified tax professional through a company like H&R Block, to handle the paperwork and tax calculations.

Janet Berry-Johnson is a Certified Public Accountant. Before leaving the accounting world to focus on freelance writing, she specialized in income tax consulting and compliance for individuals and small businesses. She lives in Omaha, Nebraska with her husband and son and their rescue dog, Dexter.