Tax Consequences of a Short Sale

I attended a good class yesterday on the tax consequences of a short sale. One of the biggest concerns a seller has in a short sale is tax liability on the amount of debt that the lender forgives. According to Marcos Goodman, the CPA who taught the class, here's generally the way it works:

Let's say the homeowner owes $250K on a property that sells for $150K. The $100K difference represents a cancellation of debt, or "phantom income" to the seller.

The first question to ask is, is the property a primary residence or an investment property?

If it is a primary residence, the Mortgage Relief Act allows for up to $2 million in debt forgiveness for purchase money and for refinance. The lender issues a 1099c to the seller, and because of the Mortgage Relief Act, no tax is owed on the phantom income.

If the property is an investment property, i.e. a rental, it will NOT qualify for the Mortgage Relief Act. The seller still gets a 1099c - that's the bad news. The good news is that the seller can show the loss on his taxes so he will net zero.

The second question is, does the debt represent non-purchase money (meaning that the seller took money out of the house to buy a boat, take a vacation, pay bills etc.) That's the big tax gulp in that non-purchase money is NOT covered by the Mortgage Relief Act.

When that sounds like your situation, a consultation with a CPA is definitely time and money well spent.