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Foreclosure Vs. Short Sale: Avoid Owing Tens Of Thousands Of Dollars In Taxes

By Donna S. Robinson | July 1, 2015

If you are behind on your mortgage and worried about foreclosure, chances are you may have heard that a short sale can help you avoid foreclosure. But depending on your personal circumstances, you may find that a foreclosure is a “better” choice than a short sale.

short sale

A “short sale” means that a mortgage lender has agreed to allow a borrower to sell their home for less than the amount needed to pay off the mortgage. If you owe $190,000 on your mortgage, but you can only sell your home for $150, 000 you are “selling short” to the tune of $40,000.

The lender may agree to forgive this debt and allow you to walk away without owing them any more money. But they will have to send you a 1099-C form for the amount that they have “forgiven”. And the IRS forgives no one. They will consider that $40,000 to be “imputed income”, meaning that you could end up owing thousands of dollars in income taxes, when you file next year. Yes it's insult to injury, but that is the downside of short sales. You get out from under the mortgage, but if you are not careful you may end up with a major tax liability.

Foreclosures Just Ahead Green Road Sign concept

Short sales were relatively rare prior to the housing crisis, but with millions of homes facing foreclosure, the short sale process became more popular. For the desperate borrower it was considered preferable to a foreclosure simply because the damage to one's credit was reduced, and a foreclosure would supposedly be devastating because it would remain on a credit report for 7 years.

For the past several years short sales have been exempt from imputed-income taxes. Because of the housing crisis, back in 2007 congress decided to grant a tax exemption for most homeowners who were trying to avoid foreclosure by utilizing a short sale.

This exemption officially expired at the end of 2014 and there is little to indicate that congress might decide to extend this exemption for 2015. This means that any short sale taking place this year or in the future could generate a huge tax bill the following year.

So the typical borrower in 2015, behind on mortgage payments, and contemplating foreclosure versus a short sale would probably prefer to choose a foreclosure instead. Foreclosure wipes out the existing mortgage, and any other existing second or third mortgages as well. But depending on the terms of your mortgage, a borrower may be held legally liable for the debt in some cases. And borrowers often agonize over the idea of damaging their credit, making the choice even harder to face.

But know this – The average borrower who faces foreclosure and has all related debt wiped out, may be able to purchase another home in as little as two years after the foreclosure has been finalized. If you have documented income, do not incur other debts in the meantime, and no other major credit related problems, it's not that difficult to overcome the results of a foreclosure. There is no longer the stigma associated with foreclosure that there once was.

On the other hand, owing the IRS a tax bill of $10,000 for “imputed income” is a huge barrier to short sales for the average borrower. Before you do anything get good advice from an expert who can address your personal situation. Don't let anyone talk you into a short sale unless you understand how this might affect your personal taxes. Trading one debt related problem for another is not a good solution.

There are different issues for each borrower to consider when making this difficult choice.

I'd recommend discussing your specific situation with a tax professional or an attorney to determine what your actual liability might be and compare your options. When it come to choosing between a foreclosure or a short sale, it's very important to make an informed decision.

About the author: Donna S. Robinson is an Atlanta native, 18 year veteran of the real estate industry and residential real estate market expert. She is the author of "Real Estate Investing Fundamentals & Strategies". Follow her on twitter @donnaconsults  Watch her videos here. read more articles and contact her about real estate business consulting services on her website.

Donna S. Robinson has been involved in the real estate industry since 1996. A licensed agent and real estate investor, she is a recognized expert on residential real estate investing. Her course, "Fundamentals & Strategies For Real Estate Investing" is approved for CE credit by the GA Real Estate Commission. She has authored several books on real estate investing, and consults with residential investment companies. She also offers coaching services to real estate investors.

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  • One comment on “Foreclosure Vs. Short Sale: Avoid Owing Tens Of Thousands Of Dollars In Taxes”

    1. Donna, please verify this..... with a Short Sale you are issued a 1099-C, BUT with a foreclosure you are issued a 1099-A!!!! Both will need to be reported on your income tax, so I'm not sure about your advice to these homeowners? The 1099-A will be a higher amount of loss as the lender/investor will include all of the foreclosure fees on that form that would not be there for a short sale, and your chances of selling higher in a short sale is greater than the amount they will get with a foreclosure sale. I'm thinking the 1099-A would be much higher.

      Gwen Brindley REALTOR

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