It’s the Law: Avoid tax problems after short sale

Q: I have a property that has gone down in value. It is now worth less than the mortgage. I have a buyer who will pay the appraised value, but that is less than the mortgage payoff. My Realtor has convinced the lender to accept less than full payoff and we are proceeding to closing. I think this might affect my credit, but will it affect my income tax return.

A: Recent turmoil in the mortgage and real estate markets has been accompanied by an increased willingness on the part of lenders to accept less than full payment in satisfaction of mortgage debt. In some cases, this is accomplished through a sale by the debtor to a third party, where the sale price is not high enough to pay off the mortgage. This is known as a short sale.

In other cases, lenders have accepted deed from the owner in lieu of foreclosure and as satisfaction of the amount owed.

Lenders in these cases generally review the finances of the owner, other assets of the owner and possibility of collecting any deficiency if suit is pursued. Real estate market conditions in the local market are also considered, as many lenders want to avoid owning property in distressed areas to the maximum possible extent.

Documenting the transaction and presentation to the lender are important. The lender must be convinced that accepting less than full payoff makes financial sense under the circumstances. Assistance of an experienced attorney can be very helpful in preparing a short sale package for the lender.

In a short sale or deed in lieu of foreclosure, the transaction is reported to credit bureaus by most lenders as a compromised debt. This hurts the credit rating of the debtor. It can get worse. The Internal Revenue Code provides that a taxpayer’s gross income includes income from discharge of indebtedness. That means the debtor may have to pay income tax when the creditor accepts less than the full amount due, as the difference will be gross income to the debtor.

The problem is slightly different where a lender accepts a deed in lieu of foreclosure and in satisfaction of the mortgage. A deed in lieu of foreclosure is treated as a sale. The debtor receives income to the extent that the mortgage debt exceeds fair market value of the property. If the property is actually worth more than the mortgage, the debtor generally has no income from the transaction.

In a short sale, it is hard to argue that the property was worth more than the mortgage debt. A big part of convincing the lender to accept less than full payment is proving market value of the property is less than the mortgage. Hence, in most cases short sales the debtor is generally required to include in gross income the difference between the amount of indebtedness and the amount of actual payment.

Even if the debtor allows the property to go through foreclosure, the debtor will usually have to report discharge of indebtedness income where the mortgage balance exceeds fair market value of the property.

These rules do not apply to all transactions. Certain discharges of principal residence indebtedness between January 1, 2007 and January 1, 2010 are excluded from gross income. Bankruptcy or insolvency can also avoid attribution of gross income from discharge of debt. And, if the pertinent mortgage was a mortgage accepted by the former owner when he sold to the debtor, reduction of the amount due is treated as a change in purchase price and not as discharge of indebtedness income.

A number of people have been forced into bankruptcy after short sale or deed in lieu, when it came time to pay their taxes. Paying taxes on discharge of indebtedness was not part of their plan. This is a complex area in which good legal advice is critical.


William G. Morris is a lawyer with offices at 247 N. Collier Blvd., Marco Island. The column is not intended to be legal advice for specific circumstances. General questions can be sent by e-mail to or by fax to (239) 642-0722. Read other columns at

© 2008 All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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