One of our team members asked the following question today:

Can you or the team answer a question about 1099 income on a short sale. I thought a home owner who sold via a short sale wasn’t liable for the difference with the Debt Forgiveness Act?

I’ve just received an approval from the bank on my short sale but they say the seller will be issued a 1099 for approx. $150K. She would do better with a foreclosure than have that type of tax burden.

Here is the answer by Deborah Beneke, CPA at Olsen Thielen

Regardless of whether the transaction is covered under the Debt Forgiveness Act or not , she will be issued a 1099. Further if the property goes into foreclosure, a 1099 will also be issued and she could still be liable for debt forgiveness income depending upon her circumstances.

However if she does qualify for the exemption available under the Debt Forgiveness Act, the amount of debt forgiveness income exclusion must be reported on Form 982 on her individual tax return. As a result, even though a 1099 was issued she will not have any tax liability.

Again, she must qualify for exemption. It must have been her principal residence two out of the last five years. AND the debt that is to be excluded must be qualified residence indebtedness. In other words, if she refinanced on the property and used the proceeds for other uses (for example to pay off credit cards), the debt forgiveness income would be taxable up to the amount used for other purposes.

If she can prove insolvency or is in bankruptcy, there would be no debt income either. Again a Form 982 needs to be filed. She should consult her tax professional to analyze her situation and determine if she would be subject to adverse tax implications. Renting out the property should not be a problem if it is short term. She will need to pick up net rental income (if any) and recapture any depreciation if there is a gain on disposal (unlikely).