In general, a short sale transaction can be a good alternative for some who are unable to secure loan modifications and want to avoid foreclosure. However, they aren’t the easiest process to navigate and can leave you short in the end if not handled properly.
Selling a home through a short sale causes a two-fold problem with the IRS. The sale of the home is viewed as income if the home is sold for more than is owed on the home. This means that it is considered a taxable gain, which is subject to taxation. In some cases, the debtor may be able to be exempt from taxes on the gain up to $250,000 or $500,000 if married filing jointly. If the home is sold for less than is owed it is considered a loss, which is not taxable by the IRS.
However, selling a home through a short sale for less than is owed may not create a direct taxable income, but it does create what is called a deficiency balance. This balance is the difference between what is owed on the debt and what the home was sold for. In most cases, lenders waive the requirement of payment for the deficiency balance. A waiver of this debt balance creates a cancellation-of-debt income, which is considered taxable. Although the debtor may not owe taxes on the sale of the home due to a loss, they may still be responsible for paying taxes on the taxable deficiency balance waiver.