Many people will be bewildered by that question. Who ever heard of paying income tax even when you sell you home for a loss?

Well, the IRS has a little known habit of charging people income tax on debt that they were responsible for paying and were relieved of that responsibility.

This could have been through a foreclosure, where the house was sold for less than the outstanding debt, a mortgage restructuring where the amount of the loan was reduced or through a short sale.

Just for the record, a short sale is where the bank lets someone sell their property for less than the amount owed to the bank.

Why would the bank do this?

Because they would rather take a known loss than gamble and perhaps face a bigger loss later. If they were to foreclose on the house, there is no telling how much they could get sell it for at that time. In a declining market like we are in now, it is virtually certain that the longer the bank has to hold the house before being able to sell it, the less they can sell if for and the larger the loss they would sustain; especially with the legal costs and fees for doing the foreclosure, the loss of interest income, security, repairs, administrative expenses, etc. you can see the logic.

The short sale is not easily accomplished, however; especially for someone with little or no experience in the process, like a homeowner.

First, you have to find the right department in the bank. Most times when the borrower calls the bank, they are directed to the collections department. Their aim is to get the borrower to send in payments, so they can make a commission.

Borrowers really need to connect with the Loss Mitigation department. They are charged with limiting the banks losses.

They will request financials on the borrower to make sure they cannot afford their payments and are not just trying to get out of a tight spot.

They will also need a BPO, a Broker's Price Opinion. This is an estimate of current fair market value for the property given by a realtor, which should include any costs of repairs. This is a big factor in the bank's decision of how much the property might be sold for and therefore how much of a discount to allow.

Finally, the bank would prefer to have a qualified buyer lined up to buy the property, since they do not want to prolong the process any more than they have to after approving the short sale.

The above process takes months. There is a lot of going back and forth, lost documents, requesting additional information of the borrower, speaking with different people all the time, etc.

I have seen cases where the borrower was still negotiating with the bank when the foreclosure proceeded and the house was lost to foreclosure in the midst of negotiations. This is really a process that calls for an experienced negotiator, knowledgeable about the process and the institution.

Ironically, if the short sale is consummated, the borrower's troubles may not be over. The bank may continue to pursue the borrower for the deficiency, the difference between the sales price and the mortgage balance.

There may be a taxable issue for the borrower as we mentioned.

In the past, the bank would issue a 1099-A for the amount of the bank's loss to the borrower and he would have to pay income tax on that amount.

However, the government has passed a law that excludes certain borrowers from this tax.

The Mortgage Forgiveness Debt Relief Act of 2007 says that for foreclosures, short sales and mortgage restructurings for less than the current balance on the mortgage, there will be no tax on the forgiven debt, if...

• The debt relief was incurred between 2007 and 2009
• The debt was for purchase and improvement of the house
• The debt was secured by the borrower's primary residence
• The amount forgiven was no more than $2 Million for a married couple

So, you can see if you did a short sale on a rental property or even a vacation home, the tax would be due.

If the mortgage on your house was a cash out refinance to pay off credit cards and to buy another property or to take a trip or pay off medical bills, the deficiency would be taxable.

In these cases, the only way around the tax would be for the borrower to declare bankruptcy, as the IRS says that if you are provably insolvent; you liabilities are greater than your assets, you will not be liable for the tax.

If you are trapped in your house; you can't sell it because you cannot get more than the mortgage balance, get in touch with a knowledgeable, experienced short sale expert to help you.

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