In a challenging real estate market, homeowners may be forced to sell their house for less than they paid for it — or worse, less than they still owe on it. Whether due to job loss or transfer, or inability to make payments resulting in foreclosure, a homeowner in this situation has another problem to consider: tax consequences. Selling a house "short," meaning the sale price is lower than the mortgage debt, has no benefits as far as the Internal Revenue Service is concerned. In fact, such a transaction can add to the sellers' financial burden by causing tax consequences.
Selling Your Residence
The bottom line, according to the IRS, is that you cannot deduct a loss on the sale of your primary residence on your income taxes. While you can offset certain gains when you sell your home for a profit, and you can claim certain investment losses when you itemize deductions, you cannot claim the loss on your main home, which the IRS defines as where you live most of the time. Any time you are losing money on a home sale, you will want to consider consulting an attorney or financial expert who understands the latest laws and how they apply to your particular case.
The Original Price Matters
In some cases, particularly when a homeowner has more than one mortgage, he may owe more than the home is worth. However, whether the sale results in a gain or loss for tax purposes depends on the original purchase price, not the amount on the mortgage or mortgages. In other words, a seller who paid $300,000 for a home, has $350,000 in mortgages and sells for $325,000 technically made a $25,000 profit on the home even though he owes more money to a lender. That means he may need to pay taxes on the $25,000 "gain" over the original purchase price. Fortunately, under IRS rules, he likely can exclude the profit from his taxes, avoiding adding to the financial burden.
In the event of a foreclosure or short sale, a lender may forgive some or all of the debt owed by the homeowner. The problem is, you could face capital gains taxes or debt cancellation taxes, depending on how the loan is structured, and how the foreclosure is handled. For instance, when a lender takes your home through foreclosure, it is considered a sale, and you could be taxed if the outstanding debt is greater than the original purchase price. On the other hand, if you surrender your house through a transfer to the lender in lieu of foreclosure, you may be taxed on the forgiven debt — the difference between the home's value and what you owe the lender.
Selling Rental Property
If the house you are selling at a loss is not your main home, but a rental property, the loss is tax deductible. That means the IRS allows you to deduct the loss in full against your ordinary income when you are doing your income taxes. As with selling your main home at a loss, you will want to consult with a real estate finance expert to make sure you are following the appropriate tax laws.
Eric Strauss spent 12 years as a newspaper copy editor, eventually serving as a deputy business editor at "The Star-Ledger" in New Jersey before transitioning into academic communications. His byline has appeared in several newspapers and websites. Strauss holds a B.A. in creative writing/professional writing and recently earned an M.A. in English literature.