Cancelled Debt, Foreclosure, and Short Sales
Owning a home is a major financial obligation, and sometimes it becomes a little too much. Foreclosures, short sales, and cancelled mortgage debt can be confusing and overwhelming. Here are the differences, and how they can affect you.
First, if your home is foreclosed or you voluntarily give up the property, the remaining balance on the mortgage debt is considered a sale by the IRS. If you sell your home for less than what is due on the mortgage, you are considered “underwater” and it's called a short sale.
So what’s cancelled debt? Cancelled debt is the difference between your home’s current fair market value and what you owe on your mortgage. It can be an oxymoron, because even though the debt was supposed to be cancelled, the IRS can see it as taxable income, which can mean higher tax liability for you.
Tax Law Update: The exclusion for cancelled mortgage debt expired at the end of 2017, and has not yet been extended for tax year 2018.
This is where the mortgage holder repossesses the home due to the homeowner’s failure to keep up with the mortgage payments. Though this process normally takes several months of nonpayment to begin, each mortgage and lender is different.
As an alternative to getting foreclosed on, you may opt to voluntarily return the home to the lender. This process simply means you sign the property back over to the mortgage holder.
Fact: While returning a home and a foreclosure both affect your credit, returning a home will not leave a foreclosure on your credit report, which will stay there for up to seven years.
However the home gets back in the hands of the lender, the IRS considers that a sale happened. You must calculate whether you took a gain or loss. If you took a loss – the debt exceeds fair market value – you have a cancelled debt.
If you owe more on your home than it's worth now, your home is considered “underwater,” sometimes euphemistically called “negative equity.” If you sell your home for less than your remaining mortgage balance, you have cancelled debt.
If you're facing foreclosure, you may qualify for a short sale of your home. Though not ideal, it's still better than a foreclosure.