When an individual can no longer afford their mortgage, they may opt to do a short sale. In the case that the banks have negotiated a deal to short sale their home for a price less than the amount owed, the lenders are forgiving a portion owed from their mortgage. Normally, cancelled debt is considered income by the IRS.
As of 2007, homeowners are no longer penalized for the short sale of their primary home under the "Mortgage Forgiveness Debt Relief Act". This law allows up to $2 million in cancelled debt for their principal residence to be excluded from taxes. To qualify under the Mortgage Forgiveness Debt Relief Act and exclude cancelled debt from your short-sale you must:
- Have the cancelled debt from the short-sale of your principale residence
- The debt/mortgage was originally incurred to buy, build or substantially improve your principal residence
The Mortgage Forgiveness Debt Relief Act does not apply if you short-sale a rental property/vacation home/second home. Also, there is no relief for home-equity loans or cash out mortgage refinancing, unless some of those proceeds were used to make improvements on your home.
For those who are not protected under this law, you will have tax liabilities on the canceled debt. The canceled debt is considered income and be taxable. However, if your total debt is greater than your total assets, aka you are insolvent, you may qualify for an exemption on your tax liabilities as an "insolvent". However, you will need to prove your insolvency by filling out the IRS Form 982: Reduction of Tax Attributes Due to Discharge of Indebtedness.