The foreclosure process is one that no one wants to experience firsthand, which is why many people seek alternatives to avoid foreclosure. While this strategy can produce some great benefits, it also comes at a price. Besides the additional effort involved with a deed in lieu of foreclosure or a short sale, there are also some tax implications that should be considered before you pursue either one.
The Tax Trap
Many people do not know that pursuing foreclosure alternatives can cost them at tax time. When you sell a home through a short sale, the proceeds from the sale go to the lender to pay off the mortgage. However, rarely does the short sale bring in enough to cover the full amount owed, leaving you with a deficiency balance. Some lenders will require you to pay this remaining amount. If you are repay the deficiency balance you will….
In some cases, the lender may not require you to repay the remaining amount and, instead, forgive the deficiency balance. If the deficiency balance is forgiven, you may be held liable for the taxes associated with the forgiven balance. The IRS considers forgiven debt amounts to be taxable. Known as debt discharge income, the IRS will require you to file a Form 1099-C. This “cancellation of debt” form is required in all transactions in which a debt is forgiven.
Before you begin to worry about pursuing a short sale or deed in lieu it is important to note that there is help for many underwater homeowners. The Mortgage Forgiveness Debt Relief Act of 2007 may exempt borrowers from paying taxes on their deed in lieu or short sale transaction if (1) the home was their primary residence and (2) the mortgage was used to build, purchase or improve the home.