A common question I am asked when discussing real estate short sales is what happens with the debt that is not paid.

Below are some different articles that discuss the possible tax implications of a short sale.  Each article has examples. 

I provide these simply for informational purposes, not as tax advice or any other reason.

ARTICLE 1

The following is from an article entitled Tax Consequences of a "Short Sale" of Real Estate vs. Foreclosure dated 8/2/08

Congress has passed and President Bush has approved H.R. 3648, the "Mortgage Forgiveness Debt Relief Act of 2007." The legislation is effective for discharges of indebtedness on or after January 1, 2007 and before January 1, 2010. The Federal Bailout Legislation H.R. 1424, passed on October 3, 2008, extended this relief through December 31, 2012.

Under the new law, a discharge of "qualified principal residence indebtedness" is excluded from taxable income.

Short sales are taxed under the same rules as foreclosures.

Recourse debt cancellation is not satisfied with the surrender of the property, so any debt not satisfied with the sale proceeds would be taxable as cancellation of debt income, except for certain "qualified principal residence indebtedness." See section on "tax relief" above. (Rev. Rul. 92-99, 1992-2 CB 518. Also see Treasury Regulations Section 1.1001-2(a)(2).)

There are additional rules as to how this debt is treated in the tax code, so I recommend reading the complete article and talking with your accountant.

Article 2

From Tax Consequences of Foreclosure, Short Sale and Deed in Lieu of Foreclosure

The tax results of a distressed property disposition depend on whether the loan is a “recourse” loan or a “non-recourse” loan.

If a lender’s sole option for recovering on the loan is to take back the property, it is a non-recourse loan. The non-recourse aspect of a loan may be spelled out in the loan documents, or it may be a matter of state law, as it often is in the case of purchase-money loans and seller-financed loans for owner-occupied residential property.

If the lender can pursue the borrower personally for any shortfall, it is a recourse loan. In situations where there is a shortfall on a recourse loan, the lender is supposed to send the IRS and the borrower a form 1099-C reporting the borrower’s COD income.

The above website includes examples.

Article 3

The actual IRS Website on Home Foreclosure and Debt Cancellation.  Specifically, they write:

Update Dec. 11, 2008 — The Mortgage Forgiveness Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualify for this relief.

Article 4

Smart Money released an article on April 22, 2009 called the taxing consequences of short sales which gives a review of short sale tax basics

The important thing to understand is that a real estate short sale can potentially result in a taxable gain and/or taxable DDI. Thankfully, you can probably exclude the gain from taxation under the federal home sale gain exclusion deal, and you might be able to exclude some or all of the DDI, too, under the favorable exceptions explained in this article.