What Happens If I Sell My House for Less Than I Owe?

When a homeowner sells a property for less than the amount owed on the mortgage, they are in a situation often referred to as being “underwater” or having negative equity. This means the outstanding debt on the home exceeds its current market value. Navigating such a sale involves a complex interplay of financial considerations, credit implications, and potential tax consequences. Understanding these various aspects is important for anyone facing this challenging circumstance.

Understanding the Financial Implications

Selling a home for less than the mortgage balance creates a financial shortfall, which is the difference between the sale price and the total amount owed, including selling costs. To calculate this, subtract the net proceeds from the sale, after accounting for real estate commissions, title fees, and other closing expenses, from the outstanding mortgage principal. Closing costs typically range from 5% to 10% of the sale price. For instance, if a home sells for $250,000 with $20,000 in closing costs, but the mortgage balance is $280,000, the shortfall is $50,000.

This remaining debt, often referred to as a “deficiency,” typically transitions from a secured debt (backed by the house) to an unsecured debt. The lender still expects repayment of this amount, even though the property has been sold. While a short sale can prevent financial fallout of a foreclosure, it does not erase the obligation to the lender for the unpaid balance. The lender may agree to forgive this debt, or they may pursue its collection.

Impact on Your Credit

Selling a home for less than the amount owed can affect a credit score. Homeowners often see a drop ranging from 50 to 150 points, with those who initially have higher credit scores experiencing a greater decline. The exact impact depends on the individual’s credit history and whether mortgage payments were missed prior to the sale.

A short sale remains on a credit report for up to seven years. The entry may appear as “settled for less than the full amount” or “account legally paid in full for less than the full balance.” While a short sale is often less damaging than a foreclosure, it still signals to future lenders that a debt was not repaid as originally agreed.

Future borrowing for a new mortgage can be impacted by waiting periods. For conventional loans, a waiting period of two to four years may apply. Federal Housing Administration (FHA) loans typically require a one to three-year waiting period, while Veterans Affairs (VA) loans can have a waiting period as short as zero to two years. Maintaining timely payments on other debts and demonstrating financial stability after the short sale can help improve credit over time.

Tax Consequences

When a lender agrees to accept less than the full mortgage balance, the forgiven amount is considered Cancellation of Debt Income (CODI) by the Internal Revenue Service (IRS). This amount is taxable and must be reported as ordinary income. Lenders issue Form 1099-C for any forgiven debt exceeding $600.

However, certain exclusions can prevent CODI from being taxed. The Mortgage Forgiveness Debt Relief Act of 2007 provides an exclusion for qualified principal residence indebtedness. This allows homeowners to exclude up to $750,000 ($375,000 for married individuals filing separately) of forgiven mortgage debt from their taxable income if the debt was incurred to acquire, construct, or substantially improve their main home. This exclusion currently applies to debt forgiven through December 31, 2025.

Another exclusion is for insolvency. If a homeowner’s total liabilities exceed the fair market value of their total assets immediately before the debt is canceled, they may be able to exclude the CODI up to the amount of their insolvency. This exclusion requires filing IRS Form 982 with their tax return. Debt discharged through a bankruptcy case is also not considered taxable income. Consulting a qualified tax professional is advisable for specific guidance on these tax rules.

Deficiency Judgments and Lender Actions

A deficiency judgment is a legal order allowing a lender to pursue the borrower for the difference between the outstanding mortgage balance and the amount received from the sale of the property. This means that even after a short sale, the homeowner could still owe the remaining debt. For example, if a home with a $300,000 mortgage sells for $260,000, the $40,000 difference is the deficiency.

The ability of a lender to obtain a deficiency judgment varies by state law. Some states have “non-recourse” provisions that prohibit lenders from pursuing borrowers for deficiencies after a foreclosure, though these may not apply to short sales. Other states are “recourse” states, where lenders can seek a judgment unless the short sale agreement includes a specific waiver of the deficiency.

If a deficiency judgment is granted, the lender can employ various collection methods to recover the debt. These can include wage garnishment or bank levies. Lenders may also place liens on other assets owned by the borrower, affecting future property sales or financial transactions. Homeowners should negotiate with their lender to waive the deficiency during the short sale process and ensure any such waiver is clearly documented in the final agreement.

Navigating the Short Sale Process

The short sale process requires explicit approval from the mortgage lender, as they must agree to accept less than the full amount owed on the loan. Homeowners typically initiate this process by demonstrating a financial hardship. This could include job loss, medical expenses, or divorce.

To support the request, homeowners must submit documents to the lender. This includes a hardship letter, financial statements, bank statements, and tax returns. A comparative market analysis (CMA) or appraisal is also often required to assess the home’s current market value.

Working with a real estate agent experienced in short sales can streamline the process. These agents assist with pricing, marketing, and negotiations with the lender. The lender must approve the proposed sale price and any terms related to the deficiency before the transaction can proceed. The entire short sale process can take several weeks to many months, depending on the lender’s procedures and market conditions.