Seller's Benefits and Tax Ramifications from a Short Sale

Benefits to the Seller

Short sale acceptance may have lesser tax liability than foreclosure for two reasons:

  1. The property has obtained the highest/best purchase offer price the market will currently bear, thus maximizing the sale proceeds credited toward the loan default.
  2. The senior lien holder may allow any junior lien holder a portion of the proceeds from the short sale. This may decrease the amount of debt relief offered the seller.

How Seller Credit is Affected

Acceptance and completion of a short sale may appear on the seller(s) borrower(s) credit bureau report as:

  • Settled
  • Paid
  • Short Sale
  • Offer and Compromise

Possible Seller Tax Ramifications

When Cancellation of Debt (COD) occurs, the Internal Revenue Service (IRS) treats any portion that the lender did not require the borrower to pay as taxable income. In other words, the difference between the amount due on an obligation (the face amount of the debt) and the amount paid to settle it may be taxable. This taxable event occurs when any of the following happen:

  1. The debt is bought for less than the face amount,
  2. The creditor agrees to settle for less,
  3. The creditor simply cancels the total debt,
  4. The debtor walks away from the property and the lender forecloses without seeking further judgment, or
  5. The debt is discharged in bankruptcy court.

It is important to note that certain borrowers may be identified by their tax professional as insolvent. The term insolvent means having more liabilities than assets and insolvency is determined on the basis of the value of those assets and liabilities immediately before the discharge. The IRS codes require a taxpayer be able to prove their insolvency.

Yet the IRS also said that where non-recourse debt exceeds the underlying propertys fair market value (FMV), forgiveness of part of that debt could result in discharge of indebtedness income where the debtor is not bankrupt or insolvent.