Identification

• When a commercial lender forgives a loan or a portion of a loan, the Internal Revenue Service considers that income, which means the forgiven portion may be subject to income tax. The Mortgage Debt Relief Act of 2007 gives some exemptions to sellers involved in a short sale transaction if the seller qualifies.
  
  

Function

• The federal government's Making Homes Affordable Program encourages lenders and troubled property owners to pursue short sales over foreclosures, as foreclosures are more expensive for lenders and more devastating to a neighborhood. A short sale normally occurs when property values have dropped, causing a borrower to be upside down in her loan. This means she owes more on her mortgage than what the property is worth at the current market value.
  
  

Features

• Before agreeing to a short sale, a lender typically has a borrower prove the property's value is less than the loan amount. This is done with an appraisal, comparative market analysis or broker's price opinion. To determine the estimated current market value, sale prices of recently sold comparable properties are reviewed. The lender also looks at the seller's ability to continue meeting the loan obligation.
  
  

Considerations

• When a lender agrees to a short sale, he does not necessarily agree to forgive the unpaid balance. After the close of the short sale, the lender may issue a deficiency judgment against the borrower. Since the lender is not forgiving the amount, the borrower doesn't owe income tax, as there is no forgiven amount to tax.
  
  

Significance

• Before entering into a short sale, the seller should consult with an attorney and accountant to determine if the short sale is the best option and whether the seller will be liable for the unpaid balance or for income tax on any forgiven amount. The Mortgage Debt Relief Act of 2007 applies to some debts forgiven in the calendar years 2007 through 2012, as of October 2010. The exception applies to principle residences and up to $2 million of forgiven debt ($1 million if married and filing separately). If the debt was forgiven for reasons other than a decline in property values or changes to the seller's financial conditions, such as for services supplied to the lender, the exemption does not apply.