Most homeowners don't realize that any mortgage principal greater than $600 that a lender agrees to cancel is considered income by the IRS, and is taxable. In other words, you may owe taxes on that "income", even though you did not receive any money!

Both homeowners and investors benefit from cost basis tax rules. The cost basis of a property is the cost of the property plus improvements. If you sell a property for less than the cost basis of the property, you have a loss. This offsets any "income" from the cancellation of debt in a short sale by a lender.

For example, using simple numbers, let's say you paid $100,000 for a property, with 10% down ($10,000), and then sold the property for $50,000. Your cost basis is $100,000 and your loss is $50,000. Because you put $10,000 down, the lender lost $40,000. So you have a net loss of $10,000. No tax is paid on a loss. You can then apply that loss to past years tax returns for a refund, or roll it forward to use in a similar capital gain in the future!

In general, the sale price doesn't really matter, because the lower the sale price, the greater the amount of cancelled debt, but also the greater the loss. Depreciation has to be added back in, but is minor for any property bought and sold within a few years.

Historical Use

Some borrowers received full residential purchase money loans while others received investment property loans and/or used HELOC's, or any combination of these loan products to acquire investment properties. The historical use of the property is an important issue because if you purchased a property as a residence before you decided to rent the home, then you can take advantage of anti-deficiency laws.

Insolvency