Short Sales: General Tax considerations.

Generally, if a bank forgives a debt (e.g. the short seller’s deficiency amount), the debt forgiveness constitutes “cancellation of debt” (COD) income under IRC § 61(a)(12).  Under that section COD income is taxable income which will be reported on the taxpayer’s 1040 form.  This general rule, however, may not apply in short sale situations.  Per IRC § 108(a)(1)(E), a taxpayer does not have to include COD income when the discharged indebtedness constitutes “qualified principal residence” indebtedness discharged from January 1, 2007 and January 1, 2013. 

Qualified principal residence indebtedness means acquisition indebtedness as defined under IRC § 163(h)(3)(B).  Generally, this means debt that was incurred in acquiring, constructing, or substantially improving the taxpayer’s principal residence and is secured by the residence.  See generally § 108(h) and § 163(h)(3)(B).  Note that this definition does not include all types of debt on a home, specifically refinance debt and second mortgage situations, and the taxpayer needs to verify that their situation falls within all of the statutory definitions of “qualified principal residence” and “acquisition indebtedness.”  A seller that is considering selling his house short should verify the tax implications of the short sale with a competent advisor prior to entering into any agreement to sell the house.