Short sale taxes are taxes charged to homeowners who sell their home to a buyer for less than the amount owed on their mortgage. This process is known as a short sale, and the mortgage lender generally forgives the remaining debt of the borrower. The forgiveness of debt is considered income for the borrower, which is subject to short sale taxes. In the United States, an Act of Congress has provided some relief for those homeowners who have undertaken a short sale on their primary residence, allowing elimination of the tax for debt forgiveness of up to $2 million US Dollars (USD).
Many homeowners who fall behind on their mortgage payments have little recourse to try and escape this difficult financial situation. If a home is foreclosed, the credit rating of the owner will take such a hit that buying a home in the future may be close to impossible. A short sale is often beneficial to all sides. The borrower gets out of the debt, while the lender takes less of a financial hit from the forgiven debt than it would from foreclosure costs. But homeowners need to be aware of short sale taxes before they undertake this process.
Basically, short sale taxes are imposed because the relief of debt is considered to be a form of income. Homeowners who aren't aware of this might be hard-pressed to pay the taxes when they are levied. The lender generally provides a tax form to the borrower when a short sale is executed, listing the details of the debt forgiveness.
For an example of how short sale taxes work, imagine that a homeowner owes $750,000 USD on his mortgage. With the lender's approval, he manages a short sale of the house to a buyer willing to pay $600,000 USD. The lender agrees to forgive the remainder of the borrower's debt, which amounts to $150,000 USD, to avoid foreclosure. Thus, the borrower could be taxed the applicable rate on the amount of $150,000 USD.
In the United States, a 2007 Act of Congress known as the Mortgage Forgiveness Debt Relief Act was instituted as a method of helping struggling homeowners. The Act, which was extended until 2012, allows for an exemption from taxes on debt forgiveness of up to $2 million USD. One qualifying factor of this exemption is that the home must be considered the residential property of the owner executing the short sale. This eliminates those holding non-residential properties, like hotels, from the exemption from short sale taxes.