Discharge of Indebtedness Income from Short Sale - Will You Receive a 1099?

A taxpayer should be very wary when entering into a short sale without considering the tax consequences. A short sale looks better than a foreclosure because the taxpayer is forgiving debt and the lender essentially agrees to take the loss. However, although the debt is forgiven to the lender, the IRS does not generally afford the taxpayer such favorable treatment.

Historically, when a debtor is forgiving a debt by their lender, the amount forgiven will be considered income and will be subject to tax. Crane v. Comm'r, 331 U.S. 1 (1947). This applies to recourse mortgages as well as non-recourse mortgages. Comm'r v. Tufts, 461 U.S. 300 (1983). However, a recent law was passed which allows for certain types of forgiven debts to not be subject to income tax. The Mortgage Debt Forgiveness Act, passed in 2007, allows for relief for some homeowners who had their debts forgiven from 2007 to 2009. However, not every taxpayer qualifies under this new law and a number of conditions must be met to benefit.

A taxpayer may fill out IRS Form 982 to apply for a reduction of tax attributes due to discharge of indebtedness and for an adjustment to their basis, as provided in Internal Revenue Code Section 1082. Normally, a mortgage is included in the purchase price of a home, and therefore included in the basis. Upon a sale of the property, the basis would be a part of the computation for capital gains for tax purposes. In making a determination in this respect, the IRS cites Regulation 1.1017-1.

The IRS may consider each taxpayer and determine whether relief from indebtedness by a lender may also qualify for relief from taxation on that debt forgiveness. However, this is not the default treatment of forgiveness of mortgage indebtedness.

Consequently, taxpayers should consider carefully whether they might qualify for this relief. If the IRS determines that a taxpayer does not qualify, such person would be assessed with a tax, in accordance with the character of the property. Therefore, if a taxpayer short sells a property and is forgiven a mortgage of $100,000, that taxpayer could be liable for the capital gains of 15 percent (based on current tax rates for 2010) on that $100,000, which would be a $15,000 tax liability.