Tax Implications of Taking a Loss on a Home

Selling a home at a loss is every homeowner's nightmare. Unfortunately, it has become a sad reality for many. In a sluggish housing market, you might be left with no other options. When the mortgage debt exceeds the sale price of a home, it is referred to as a short sale. A short sale is a common foreclosure alternative that lets struggling homeowners avoid foreclosure and its negative credit consequences. If you are considering a short sale, it is important to understand possible tax implications for primary and investment homes.

Forgiven Debt

If the lender decides to forgive the difference between the sale price and the balance due, you will receive a form 1099-C. Although the lender is forgiving the debt, the IRS is not as forgiving. To the IRS, you borrowed the money and got away without paying. It is considered income and must be reported along with your other wages and earnings. Failing to report the debt can lead to harsh penalties and fees from the IRS. Also, keep in mind: If you receive a 1099-C, the IRS already has one, too.

Mortgage Forgiveness Debt Relief Act

The Mortgage Forgiveness Debt Relief Act of 2007 lets you exclude the income from your taxes if the home was your principal residence. If the home was a secondary or rental property, you will still need to report the income. Although originally set to expire in 2009, the relief was extended to cover debt forgiven through 2012 under the Emergency Economic Stabilization Act.

Capital Gains Tax

A capital gains tax applies when you sell a home for more than you paid. If you have a second mortgage on the home, the profit might not even be enough to cover the additional mortgage debt. The IRS only sees the profit and will require you to pay a capital gains tax if the property is a rental or secondary home. If the home is your primary residence, you are allowed to profit up to $250,000 if you are single and $500,000 if you are married.

Claiming a Loss

Although investment homes are excluded from the Mortgage Debt Forgiveness Act, there is some tax relief for owners who sell at a loss. You can claim the loss on your federal taxes. Most states also let you list the loss as a deduction. A loss on a primary residence is classified as a nondeductible personal expense.

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