How to Be Excused From the Cancellation of a Debt From a Short Sale Rental

A short sale must be approved by your lender.

If you are unable to make payments on your mortgage, your lender may agree to accept less than the total amount owing on your property. You must find a buyer willing to purchase the property and then work with your lender to secure its approval to sell the property. A short sale of a rental property triggers potential tax consequences.

Instructions

1. Find a buyer and agree on a selling price that is acceptable to the lender. If your lender approves the short sale, it will forgive the remaining balance due on your mortgage loan. For example, if the balance of the mortgage is $175,000 and the property is sold for $125,000, your lender will forgive $50,000 in debt.

2. Wait for your lender to send you IRS Form 1099-C. This form reports the amount of debt that has been canceled. It will include the name and address of your lender, the amount of debt forgiven and the fair market value of your rental property.

3. Determine the amount of taxable income arising from the cancellation of debt; canceled debt is generally considered taxable income and must be reported on your IRS Form 1040 filing. The IRS has provided an exemption for short sales occurring between 2007 and 2012 and involving a principal residence; these sales are exempt from taxation subject to certain limits. However, a short sale involving a rental property is always taxable unless you are insolvent.

4. Determine if you may be insolvent. You are insolvent when your total debts exceed your net assets. If you are insolvent immediately before the debt is forgiven you may exclude a portion or all of the canceled debt from your taxable income. For example, if your total assets total $75,000 and your debts total $125,000, you would be insolvent in the amount of $50,000.

5. Calculate the amount of debt forgiven that is not taxable. You can exclude from taxable income the amount of debt forgiven up to the amount that you are insolvent. If you are $50,000 insolvent and Form 1099-C indicates that $65,000 of debt was canceled, you would report only $15,000 as taxable income when you file your federal income tax return.

Tips & Warnings

• Consult a tax professional if you have questions regarding a short sale of a rental property.

References

• Realty Times; Short Sale Transaction a Tall Order; Broderick Perkins
• Internal Revenue Service: Publication 544 – Sales and Other Dispositions of Assets
• Turbo Tax: Tax Relief for Cancelled Mortgage Debt