If you owe someone money and they forgive the debt, effectively telling you not to worry about repaying it, the Internal Revenue Service considers this income. In a short sale, this is exactly what happens. Your home is worth less than the mortgage against it, so your mortgage lender allows you to sell it for fair market value and it typically writes off any deficiency. This deficiency is income, and you have to report it on your tax return. Whether you actually have to pay taxes on it depends on several circumstances, including when your short sale occurs.
Mortgage Debt Relief Act
In December 2006, Congress passed the Mortgage Debt Relief Act. The act allows you to avoid paying taxes on short sale deficiencies if you meet certain qualifying criteria. Unfortunately, the act isn't permanent. It expires after 2012 unless Congress takes steps to extend it. If you sold your home between January 2007 and December 2012, you probably won't owe taxes on the transaction, but if you short-sell at any other time, you might.
The Mortgage Debt Relief Act applies only to short sales of your primary residence. If you sell a rental or other investment property, it's not covered and the deficiency is taxable as income. The IRS defines your principal home as the place where you live "most of the time." This is somewhat ambiguous, but if you're living in your home until the date of the short sale, you'll typically qualify. Another IRS rule requires that you live in your home for two out of the preceding five years, but this typically applies to the capital gains tax exclusion, not the Mortgage Debt Relief Act exclusion.
The IRS caps your short sale deficiency at $1 million for purposes of exempting it from taxation. The limit increases to $2 million if you're married and file a joint return. If you're not married, and if you sell your home for $500,000 and have a $1.5 million mortgage against it, you won't pay taxes on the deficiency if your short sale occurs between 2007 and 2012. If you sell your home for $480,000, you'll have to pay taxes on $20,000 of the forgiven debt as income.
If Congress does not extend the Mortgage Debt Relief Act and you sell your home after 2012, or if for some other reason you don't qualify under the act, you might still escape paying taxes on the short sale deficiency if you're insolvent. The IRS defines insolvency as owing more than the total value of all assets you own, including retirement accounts, personal property, autos, cash, bank accounts and investment accounts. The debt is not limited to the amount of your mortgage; it includes everything you owe to any creditor. You're also exempt from paying taxes on your mortgage balance deficiency if you file bankruptcy rather than short-sell your home.