It’s not news that record number homeowners find themselves in the same untenable situation after the mortgage meltdown of 2007—owing more on their mortgages than the actual market value of their home. Some have escaped this financial nightmare by simply walking away. Others, however, have decided to take what’s arguably the more noble and unquestionably more legal avenue out of their American Dream gone wrong: to short sell.

To begin, it’s important to note that short selling in real estate is in no way related to the ethically questionable process of short selling stocks. Shorting—as it pertains to real estate—is simply the process of a homeowner selling their home at a price that is less than the value of their mortgage to avoid foreclosure (i.e. Joe’s mortgage is $300,000 but it’s market value is only $225,000). The question then arises: what happens to the difference between Joe’s sale price and his mortgage? Does the bank just forgive the $75,000?

The answer is this: sometimes yes, sometimes no. Banks have been known to forgive this difference (what they call a deficiency), but stories do abound of banks coming after homeowners for this money after the short sell. Worse yet, the IRS could consider the deficiency amount as income and charge you tax on it.

The moral is this: (1) Make sure you know where your bank stands with respect to the deficiency and (2) consult a tax expert to see if you qualify as insolvent and therefore not responsible for the tax on the deficiency amount. If you are short selling your home you are undoubtedly in a tough spot. To avoid making things more trying than they already are, simply follow these two easy precautions before you sign the papers for your short sale.

This is filed under Short Sales.

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