Selling at a Loss? Here's What to Expect From the IRS.

By Bill Bischoff
Saturday, August 11, 2007

It's a homeowner's worst nightmare: selling a home at a loss. Sadly, with the real estate market slowing, more folks are discovering that, yes, this can actually happen.

The worst-case scenarios occur when folks borrowed heavily to buy at the top of the market or took out big home-equity loans while prices were inflating -- two situations that can result in the mortgage debt exceeding the value of the home. And if homeowners in these situations have to sell, not only will they owe money to the bank but there could be some unexpected income tax consequences.

A home sale where the mortgage debt exceeds the net sale price (after subtracting out commissions and other transaction costs) is often called a short sale. If you find yourself in this situation, here's what you need to know about the federal income tax implications of short sales.

The Basics

The subject is complicated. The easiest way to explain matters is with some examples.

Example 1: Say you paid $260,000 for a home that you can now sell for a net sale price of $300,000. Unfortunately, you also have $350,000 of first and second mortgages against the property. For tax purposes, you will have a $40,000 gain if you sell because the price exceeds your tax basis in the home ($300,000 sale price minus $260,000 basis equals $40,000 gain). The Internal Revenue Service doesn't care that you're still $50,000 in the red after the sale ($350,000 of debt vs. the $300,000 sale price). The bottom line is that you can have a tax gain without any cash to show for it.

The good news is that you will probably qualify to exclude the $40,000 gain for federal income tax purposes thanks to the home-sale-gain exclusion. So the sale probably won't trigger a federal tax bill. Depending on where you live, there may or may not be a state income tax hit.

Example 2: You can also have a short sale where the net sale price is less than what you paid for the home.

Say you paid $340,000 for a home that you can now sell for a net price of $300,000. You also have $350,000 in first and second mortgages against the property. For tax purposes, you will have a $40,000 loss if you sell because the sale price is lower than your tax basis in the home.

Will the IRS let you claim a write-off for the loss? No. You can claim a tax loss only on investment property. A loss on a personal residence is considered a nondeductible personal expense for federal income tax purposes. Most states follow the same principle.

Now, what about that $50,000 that you still owe the mortgage lender in both of these examples? Good question. In most cases, the lender won't let you off the hook for any of the debt. You will have to figure out a way to pay it off, and you won't get any tax breaks for doing so.

If you're more fortunate, the lender could decide to forgive some or all of the unpaid $50,000. (This may happen if the lender thinks it's unlikely you will be able to repay the full amount.) To the extent debt is forgiven, you have what is called debt discharge income (DDI) for tax purposes. Here's what happens with that:

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