Too many consumers and real estate agents are unaware of the tax consequences resulting from the cancellation of debt. With foreclosures at a high, and short sales on every other block, it seems that many sellers think by giving the house back to the bank or by negotiating a short sale, their financial obligations will soon be over. Not so, says Lance Churchhill of Frontline Foreclosure Forum.  In his post Loan Forgiveness-After the Short Sale: Taxing What Isn’t There he points out;

"Whenever real estate is sold, whether in a standard transaction, a
short sale or a foreclosure auction, there are potential tax
consequences for the seller". He goes on to say,  "The seller may
still owe taxes to Uncle Sam — both in the form of capital gains on the
home and on the unpaid portion of the mortgage."

This "Phantom Tax" works like this; in a short sale scenario, a seller may get their lender to forgive a certain amount of their debt that the sale of the home would not cover. In other words, if their loan balance was $230,000 but they could only get a sale price of $215,000, they would be deficient by $15,000 plus any fees or prorated taxes that were required to close. Lets say that totaled another $8,000. So on the surface, the seller is getting forgiven $23,000 of debt. But Churchhill says;

"The IRS considers any canceled mortgage debt
ordinary income. This means that the amount forgiven is taxed at the same rate
— somewhere between 15 percent and 30 percent — as the sellers’ salaries. In
addition, because the IRS requires the lender to file a 1099-C form stating the
amount of the canceled debt, Uncle Sam will have a record of the exact amount
of the debt that was canceled. A seller will also receive a copy of the 1099-C
to use in filing income taxes. The seller’s home state would also consider the canceled debt as ordinary income".

There are some exceptions to the rule in which the seller may avoid tax liability. Such as,

• a discharged bankruptcy in which the deficiency was included int he the bankruptcy
• Insolvency, but the seller must prove he has more liabilities than assets
• debt that was secured by a non recourse loan
• investment properties who’s liabilities and expenses offset the tax liabilities from the cancellation of debt.

It is the sellers responsibility however to contact the IRS and explain why the amount in the 1099-C should not be counted as
ordinary income. Ans remember, a Realtor, neighbor or friend is not a tax expert. Always be sure to seek professional tax advice regarding the possible tax consequences of selling your home.

Also check out what the National Association of Realtors is doing and has been doing since the mid 90’s to fight against this "Phantom Tax"