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Do I Have To Pay Taxes After a Short Sale of My Home?

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In a Nutshell

Generally speaking, when lenders or creditors forgive part or all of a debt, it’s treated as income and you may have to pay taxes on the forgiven amount. If you decide to sell your home in a short sale to avoid foreclosure, the sale amount will be less than what you owe on the mortgage. In this case, if the lender agrees to forgive the remaining debt, will you have to pay taxes on the amount they forgive? Before deciding whether a short sale is a good option for you, you’ll want to understand the possible tax consequences. This article can help.

Written by Mark P. Cussen, CMFC
Updated December 8, 2021

Generally speaking, when lenders or creditors forgive part or all of a debt, it’s treated as income and you may have to pay taxes on the forgiven amount. If you decide to sell your home in a short sale to avoid foreclosure, the sale amount will be less than what you owe on the mortgage. In this case, if the lender agrees to forgive the remaining debt, will you have to pay taxes on the amount they forgive?

Before deciding whether a short sale is a good option for you, you’ll want to understand the possible tax consequences. This article can help.

What Is a Short Sale?

If you fall behind in your mortgage payments by more than two or three months, then you’ll be at risk of foreclosure. There are several ways to avoid foreclosure. Some people decide to get their lender’s permission to sell their home in a short sale.

In a nutshell, a short sale is when you sell your house for less than what you owe on the mortgage. Your mortgage lender must agree to take the reduced sale price for the property before you can do a short sale. If they agree to a short sale, your lender will accept the sale price as repayment for the loan. They will then either forgive the remaining balance or, in some cases, try to get a deficiency judgment to collect the remainder. Short sales are a loss mitigation option, so they require your lender’s approval. Why would a lender approve a short sale? They may do so if they think they have a better chance at getting something rather than nothing.

Short sales are one way to avoid the stress and damage of foreclosure, but they have advantages and disadvantages. When it comes to credit reporting, both will hurt your credit score significantly, but the exact amount your score will drop depends on several factors. Short sales do have one advantage over foreclosures when it comes to your credit. Having a foreclosure on your credit history can prevent you from getting another home loan for a long time. But if you have a short sale in your credit history, you can usually get approved for another mortgage much sooner. 

For example, Fannie Mae allows borrowers to get another mortgage two years after a short sale. But it won’t grant another home loan to borrowers who have a foreclosure on their record for seven years.

Tax Implications of Short Sales

Although short sales can allow homeowners to escape their mortgage debt, they also come with tax consequences. If you are considering a short sale for your home, you need to understand how the IRS treats forgiven debt.

Income Tax From Debt Forgiveness

In most cases, forgiven debt (also called canceled debt) is considered taxable income. At the end of the year, the mortgage lender will issue you a Form 1099-C showing the amount of the mortgage debt that was forgiven. This amount will appear in Box 2 of this form, and it must be reported as taxable ordinary income on both your federal and state taxes (assuming your state has an income tax). This is true for all types of forgiven debts, including credit card debts, medical bills, personal loans, and any other type of debt that is written off by the lender. 

If you sell your house at a loss, you will report this as a capital loss on IRS Form Schedule D. But the entire loss will most likely not be deductible 

In some states, lenders can’t sue homeowners for any deficiency balance. This is the difference between the home’s sale price and what’s left to pay on the mortgage. These states are called non-recourse states. They include Alaska, Arizona, California, Connecticut, Idaho, Minnesota, North Carolina, North Dakota, Oregon, Texas, Utah, and Washington. If you live in one of these states, you won’t have to pay federal or state taxes on any amount of canceled debt that comes with a short sale. 

Capital Gains and Losses

Even if you sell your house for less than the mortgage balance, it is still possible to have a capital gain on the sale of your house. Ordinarily, when you sell a home you’ll make a profit or have a loss, depending on how much you paid for it. Capital gains and losses account for this profit or loss and adjust them to account for any increase or decrease in the value of the home. This is called the adjusted basis. Your home’s adjusted basis can increase — such as if you do improvements — and decrease — such as when there’s damage from a natural disaster.

For individuals, up to $250,000 of capital gain can be excluded on your taxes. For couples filing jointly, this amount increases to $500,000. Because of this, it’s relatively rare to see short sales that result in taxable capital gains. But in cases where the short sale price of the home is greater than your home’s adjusted basis but less than the total of the mortgage and it exceeds the excluded amount above, there would be a capital gain.

If you exclude canceled debt from your federal taxes, you need to include Form 982 when you file. This can all get very complicated. The IRS has resources to help, or you can seek advice from a tax professional.

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Mortgage Forgiveness Debt Relief Act

The Mortgage Forgiveness Debt Relief Act of 2007 (MFDRA) relieves borrowers from having to report any canceled home loan debt on their income tax returns through 2021. (Although the paperwork for the short sale must have begun before the end of 2020). The Consolidated Appropriations Act (CAA) was passed in December of 2020 and extends this provision through 2025. But the maximum amount of debt that can be forgiven for tax purposes is $750,000.

This provision only applies to the mortgage for your principal residence. It doesn’t apply to second homes or investment properties. It also doesn’t apply to second mortgages, home equity loans, or home equity lines of credit, unless they were used to buy, build, or improve your primary residence. Any type of home loan that falls outside of these parameters isn’t eligible for debt forgiveness. This includes the cash-out portion of a cash-out refinance.  


Harry is forced to sell his home using a short sale. He has a primary mortgage of $250,000 and a home equity line of credit for $50,000 that he took out to build an addition onto his home. He does a short sale of his house for $200,000, and his lender agrees to forgive the remaining balance plus the line of credit. Harry will not have to report any of the forgiven debt as income for that tax year. 

Other Solutions to Debt Cancellation Income

If you are insolvent or you file bankruptcy, you may be able to reduce or eliminate the taxable income from debt cancellation.


If you become insolvent, then you may not have to report any debts that lenders forgive as taxable income. Insolvency means your liabilities are greater than your assets. Your assets include the value of all of your financial accounts, including your bank accounts, CDs, retirement plans, and any other type of investments that you own. Your liabilities are your debts, including your credit card debts, medical bills, student loans, car loans, personal loans, and back taxes. 

When it comes to your taxes, your canceled debt will be compared to the extent of your insolvency. For example, let’s say your liabilities exceed your assets by $20,000, and your lender forgives $27,000 of your credit card debt. The $20,000 of insolvency will be subtracted from the $27,000 of forgiven debt, and you would have to report the remaining $7,000 as taxable income. On the other hand, if your forgiven debt is $20,000 or less, then you would not have to report any taxable income. 


If all else fails and you become completely unable to pay off any of your debts, you can consider filing for bankruptcy. There are two types of bankruptcy for individuals: Chapter 7 and Chapter 13

Chapter 7 bankruptcy wipes out most of your debts (except back taxes, punitive damages that you owe to a plaintiff, or child support or alimony payments). Most of your creditors must forgive your debts, and you don’t have to declare this as taxable income. While this can bring great relief and give you a fresh start, it also has consequences. It will hurt your credit score and stay on your credit report for the next 10 years. It can be difficult to get new credit right after filing bankruptcy or to get good terms on your credit offers.

In Chapter 13 bankruptcy, you create a 3-5 year repayment plan and pay off or pay down your debts. Chapter 13 bankruptcy will also hurt your credit score, but it only stays on your credit report for seven years.

Upsolve can help you file Chapter 7 bankruptcy for free or help you get a free consultation with an experienced bankruptcy attorney who can help you file your case.

Let’s Summarize...

Selling your home in a short sale is a way to avoid foreclosure. The sale price of a short sale will usually be less than what you owe on your home. Your lender must approve this sale since they are the ones who will absorb the loss. The difference between the sale price and what you owe on your mortgage may be forgiven by your lender. If this happens, you may be on the hook to pay taxes on this canceled debt.

Due to recent legislation, in most cases, you won’t have to pay taxes on forgiven debt at least through 2025. Insolvency and bankruptcy are two other ways that you can escape taxation on forgiven debt.

Written By:

Mark P. Cussen, CMFC


Mark has over 25 years of experience in the financial industry, and has worked with investments, insurance and mortgages as well as income tax preparation and comprehensive financial planning. His writing work includes insurance and securities training manuals and educational art... read more about Mark P. Cussen, CMFC

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