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Tax Rules for a Short Sale on a Principal Residence

Debt cancellation occurs when lenders forgive outstanding loan amounts. The IRS requires taxpayers to report it, and in some instances, this debt may be taxable because there is no longer an outstanding obligation. However, in 2007, the Mortgage Debt Relief Act was passed. Under this Act, taxpayers may exclude income they received when their principal residence mortgages were forgiven through loan re-modification programs or through foreclosure.

Short Sale Definition

A short sale occurs when lenders allow financially-strapped home buyers to sell their home for less than the amount the borrower owes on the mortgage. Typically, lenders approve short sales because of the cost and time associated with pursuing foreclosure. Borrowers may prefer short sales over foreclosures because of penalties to credit with the latter.

Total Limit

Under the Act, up to $2 million is eligible for the IRS exclusion if taxpayers are filing jointly. The amount is lowered to $1 million for single filers. The debt must have been forgiven between 2007 and 2012. The exclusion is only provided for homes that have depreciated in value or the taxpayer is experiencing financial hardship. The IRS requires the income to be reported on Form 1099-C. This is the Cancellation of Debt form.

The lender canceling the debt sends a Form 1099-C, and the amount forgiven is provided in Box 2. Sign Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness.

No Income Limit

The exclusionary tax rules were enacted to provide taxpayers with some financial relief. Since the subprime mortgage markets crashed, foreclosures and short sales are at an all-time high. The special tax relief is provided to all taxpayers, regardless of the taxpayer's annual income amount or applicable tax bracket.

Qualified Principal Residence Indebtedness

The Act only applies to debts that were canceled for a principal residence and only for a debt secured by the principal residence. Debts canceled for an investment property or vacation property may not be excluded under the Act.

Individuals may only own one single residence at once. Furthermore, unlike the capital gains rules used for providing tax relief for the sale of a principal residence, the IRS does not typically provide tax relief for homes that were previously used as investment properties or second homes.


Since laws may frequently change, you should not use this information as a substitute for legal advice. Seek an attorney's advice licensed to practice in your jurisdiction.

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