If you own a property that is not your principal residence and agree to a short sale with your mortgage company, you may be setting yourself up for a big tax bill. Any debt forgiven by the mortgage company on property that is not your principal residence will be considered “income” to you. The mortgage company will issue Form 1099C Cancellation of Debt that you will have to claim on your tax returns. Moreover, the amount forgiven will be considered a “capital gain” and taxed accordingly. Worse yet, this tax debt is not dischargeable in bankruptcy.
How do you avoid this tax bill?
Instead of agreeing to a short sale you have the option to declare bankruptcy if you otherwise qualify for same. If you declare bankruptcy, you will discharge your personal liability for the mortgage. By doing this, you will not be responsible to make payments on the mortgage. The mortgage company will retain a lien on the property and will foreclose upon it if payments are not made, but they will not be able to sue you for the outstanding balance.
More importantly, the discharged mortgage will not be considered “income” for taxation purposes. As such, you will avoid having to pay the substantial taxes for which you would be liable under a short sale. The net result will be the same — you will have disposed of the property without satisfying the mortgage, but you will save a bundle in taxes.