Short sale tax implications are pretty complex since there are several different aspects involved. Here’s an introductory overview that will help you ask the right questions when you weigh the pros and cons of short sale vs. foreclosure.

Tax Relief Continues for Insolvent Homeowners

Prior to 2007 when the Mortgage Forgiveness Debt Relief Act went into effect, you would owe income taxes on the balance of your unpaid mortgage that was forgiven (cancelled) by your bank. Since Congress extended the Act through the end of 2013, you can still sell a home for a loss and not get hit with a huge tax bill. This doesn’t mean you should ignore the 1099-C form your bank provides when they cancel your debt. They are sending a copy to the IRS as well. You do need to complete the appropriate sections in your tax forms showing this cancelled debt, even if you don’t have to pay taxes on it. The amount of forgiven mortgage debt you can exclude from income is $1 million ($2 million if married and filing jointly).

Additional Taxation Scenarios

There may also be other short sale tax implications if the value of your property increased since you bought it. Let’s say you took out a second mortgage. You might still owe more on your home than it is worth and be “upside down” because of that second loan. This means you could end up short selling your home for more than you bought it for but less than you owe. The IRS sees that as a tax gain. Fortunately, if the home you are selling is your primary residence, you may be able to exclude part or all of this gain. Learn more about tax consequences with easy to understand examples here.

“Cash for Keys” Is Taxable

Finally, there’s the issue of relocation assistance (from the bank or as part of the HAFA program). This is one item you probably won’t be able to avoid paying taxes on. It’s income in the eyes of the IRS and must be reported as such on your form 1040. That’s something to bear in mind when you decide how to use the assistance money. It might be smart to set aside a portion to pay that tax bill.

This overview only addresses federal taxes. There may be state tax implications as well. This article is for basic informational purposes only and is not a substitute for advice from a tax attorney.