The definition of a short sale is the sale of a property where the proceeds will be less than the outstanding balance of the loan secured by the property. This may occur when a bank or finance company does not expect repayment of the loan, and accepting a lesser amount for the home seems more attractive to the lender than the costs, risks, and time-consuming nature of the foreclosure process.

Example of a short sale: A homeowner is having trouble keeping up with mortgage payments on his or her house. The homeowner owes $200,000 on the mortgage, and would like to sell. The best offer the owner can find, though, is $180,000 – leaving a $20,000 shortfall, or deficiency. The homeowner has no other resources available to pay off the loan.

The owner and prospective buyer approach the lender with a proposal: Take the $180,000 in a short sale, or risk having a non-performing mortgage on the books while the bank goes through a foreclosure process that could last for over a year – and then face legal, administrative and transaction costs, and still possibly lose money on an eventual foreclosure sale. The bank or lender must grant approval for a short sale to go through.

There’s more to this topic than the short sale definition. Keep reading to learn about the tax treatment and ramifications of short sales and what the short sale process entails, among other short sale-related information. 

Tax Treatment of Deficiencies in a Short Sale

A short sale deficiency has tax consequences for both the seller and the lender. If the lender forgives any debt as the result of a short sale, they will send a Form 1099-C to the seller detailing the amount forgiven.  Once the lender forgives an unpaid loan balance as the result of a short sale, it can then take a deduction against bad debt reserves.

The tax treatment of forgiven debt for the seller of the property depends on the timing and circumstances. The IRS generally considers debt forgiven to be income when the property is a second home or investment property.  If the debt was forgiven between tax years 2007 and 2013, and the home was a private primary residence, the Mortgage Forgiveness Debt Relief Act of 2007 may apply.

More specifically, if a home was not an investment property, second home or vacation home; the debt was forgiven between 2007 and 2013; and the need for the short sale was directly related to a decline in the market value of the home, or to a worsening financial position, or both; then the amount forgiven would not be included in federally taxable income. The maximum amount of forgiven debt that can be excluded from taxable income under this provision is $1 million ($2 million for married filers). The exclusion is not available if the debt was forgiven after December 31, 2014 – unless Congress passes another law authorizing this exclusion.

Bankruptcy and Insolvency

If the borrower declares bankruptcy, then the amount forgiven can also be discharged in bankruptcy, and rendered non-taxable. A similar provision applies if the borrower is insolvent. Under this law, insolvency exists where the borrower’s total assets are less than the total debts he or she owes as a taxpayer.

For more information related to the federal tax consequences of forgiven debt, refer to IRS Publication 4681 – Canceled Debts, Foreclosures, Repossessions and Abandonments.

The Short Sale Process

The seller will apply to the lender for approval of a short sale. Generally, the lender will expect the seller to provide some proof of financial hardship to justify the short sale. Common examples of hardships that can lead to a short sale include the loss of a job or reduction in income, an illness or injury, the death of a spouse or a divorce.

The application process can take some time – sometimes weeks or months. If there is a second mortgage on the home, or if there are other lienholders, they will also have to approve the short sale.

There is no guarantee that a lender will accept a short sale. Expect the lender to do what is in their best interest. For the application to be accepted, the short sale offer must be higher than the present value the lender expects to recover in a foreclosure. Ideally, a short sale results in a win-win-win situation for the buyer, the seller and the lender, compared to the option of waiting for a foreclosure to go through.

Ramifications and Consequences of a Short Sale

Credit agencies include short sale data on credit reports. If a client sells their home in a short sale, you can expect to see a decline in their credit score. This could make it more difficult for them to qualify for financing, mortgages or other forms of credit in the future.

Nevertheless, it may be advantageous to enter into a short sale, rather than let a lender foreclose on the home. One reason: Homeowners can still qualify for an FHA mortgage immediately after a short sale. Whereas if they wait for the lender to foreclose, FHA guidelines will impose a waiting period on access to another FHA mortgage.

Note: The FHA recently announced that it was waiving the waiting period for certain buyers, under the Back to Work Program. Not all lenders are necessarily participating, however, and buyers must meet certain criteria to qualify.

This article is reprinted from Trulia Pro blog.