Considering the Tax Consequences
While the Internal Revenue Service allows you to exclude some or all of the profit from selling your home if you qualify, the tax implications differ if you sell the property for less than its cost or adjusted basis. Even though you sell the home at a loss, if it's your primary residence you cannot deduct the loss from your income when filing your taxes. If your lender forgives any part of the mortgage debt remaining, you must report that amount as income on your federal tax return. Depending on the state in which you reside, you may be required to report as income the cancellation of debt on your state taxes as well.
Understanding the Consequences of a Short Sale
If your lender agrees to a short sale, you can sell the house for less than the outstanding balance you owe on the mortgage loan. Although a short sale helps you avoid foreclosure, it has a negative impact on your credit score. Unless the lender agrees to report the debt to the credit bureaus as paid in full, the short sale will appear on your credit report as "settled." Similar to a charged-off account, "settled" tells other creditors reading your report that you paid only a portion of the total debt you owed the mortgage lender.
Knowing Your Rights
Although some states allow lenders to sue to recover mortgage deficiencies following foreclosure, these laws generally do not apply to short sale deficiencies. Some states have laws that prevent lenders from seeking deficiency judgments following short sales. You should talk to an attorney to find out if mortgage lenders in your state can sue you for the deficiency. If the lender gets a deficiency judgment against you, it can freeze your bank accounts, garnish your wages, or place a lien on other property you own.
Dealing with Deficiency Debt
If a difference remains between the sale price you get for your property and the amount you still owe on your mortgage loan, the lender may sell the outstanding debt to a collection agency or sue you in court. To avoid the negative impact on your credit score, you can ask the lender to cancel the remaining debt -- in which case you may have to pay more taxes. If the lender refuses, offer to settle for a lesser amount by making a lump sum payment. You may even be able to negotiate with the lender to pay off the deficiency by making installment payments over time.