When an individual borrows money it is not considered an income, but if the loan or debt is forgiven then the amount borrowed becomes income. When the borrowed money is for buying a house or real estate, a drop in prices can result in short sale or foreclosure. The resulting short sale tax implications will not be too heavy, provided the tax returns of that individual are prepared correctly.
In common parlance, tax implications are the effects of a particular transaction on the taxation structure of an individual. The logic of an implication is that whenever you conduct any transaction, you either pay money, borrow it, or receive it. Based upon the taxation laws and rules that are formulated by the IRS, these transactions have some or the other effect on the taxation of an individual. Such effects are known as tax implications.
In the United States of America, expensive assets, such as cars or homes, are procured with auto loans or mortgage loans. In the due course of the loan, if the borrower faces financial hardships, and falls behind his installment payments, then he has the option of short selling the asset. This requires the consent of the lender and a debt settlement meeting or a debt negotiation process. After the lender gives his consent, the property is sold for a price that is lower than that of the total worth of the loan (which is the principal amount of the loan plus the interest payable). The loss is sustained by the lender.
Some people might question that why does the lender put up with the loss. The explanation is simple. If the borrowers economic condition deteriorates even more, then the lender may end up losing an even larger amount.
The phenomenon of short sale is largely governed by the Mortgage Forgiveness Debt Relief Act of 2007, and Emergency Economic Stabilization Act of 2008. In the year 2007, in order to curb the effects of the United States housing bubble, the Bush administration put forth the Mortgage Forgiveness Debt Relief Act of 2007.
After the short sale proceedings, the lender is left with a deficit that has been unpaid by both the borrower as well as the sale procedure. The creditor generates a form that is titled 1099-C Tax Form, in order to officially communicate to the borrower that the deficit or the remaining amount of the loan has been written off and the debt has been discharged. Conventionally, before the passage of the Mortgage Forgiveness Debt Relief Act, this written off amount was included by the IRS in a person's taxable income. For example, if you had a standard income of say $400,000 per annum and you short sell a house for $600,000 which had a mortgage of $700,000, then your short sale tax liability becomes $100,000, and the total taxable income becomes, $500,000.
In the year 2007, due to the economic recession, the Mortgage Forgiveness Debt Relief Act was passed, that made provisions for short sellers to exclude the forgiven amount (deficit) from taxable income. This provision was to last for 3 fiscal years, but the Emergency Economic Stabilization Act, increased the time margin till 2012. The short sale tax consequences are also extended to property taxes by state. Such taxes are paid in proportion to the time period for which the seller owned the property.
In case if you are planning upon a short sale, then I would really recommend you to consult the IRS and also your tax attorney, as there are several different tax provisions that you might have to consider. Also, compare the foreclosure tax implications with those of the short sale. Cases have been observed where a short sale has proved to be disadvantageous, as compared to that of a foreclosure.