A “short sale” means to sell a house for less than the mortgage owed. Depending on the lender, the difference between what is received from a short sale and what is owed on the mortgage may be forgiven. However, even if your lender agrees to a short sale, the lender may not agree to forgive the debt entirely and may require you to pay the difference as a personal obligation.
It is important to appreciate debt which is forgiven is generally treated as income by the Internal Revenue Service. In 2007, Congress amended the tax code under the Mortgage Forgiveness Debt Relief Act to exclude the forgiveness of debt related to a short sale from federal income tax under certain conditions. This exclusion is set to expire on December 31, 2012. The Mortgage Forgiveness Debt Relief Act requires: 1) the home must be your principal residence and 2) the mortgage loan must have been used to buy, build or make substantial improvements to the home. Debt used to refinance your home may also qualify for this exclusion, but only to the extent that the principal balance of the old mortgage, immediately before the refinancing, would have qualified. If these conditions are met, the amount of forgiveness is not considered as income for federal taxing purposes.
Although a short sale is one way to avoid the high costs of foreclosure, it is not without positive and negative consequences. You should be aware a short sale may incur tax implications, impact your credit score, and may require a waiting period before you will qualify for a loan to purchase another home.