What Happens If You Sell a House for Less Than the Mortgage?

Selling a house for less than the amount owed on the mortgage, often termed an “underwater” or “upside-down” mortgage, presents a complex financial challenge. This situation arises when the property’s market value declines below the outstanding loan balance, leaving homeowners with negative equity. This scenario, whether a short sale or a foreclosure, can have significant and lasting implications for an individual’s financial standing. Navigating such a situation requires understanding the potential consequences and available options.

Understanding the Deficiency Balance

When a property sells for less than the outstanding mortgage balance, the difference between the sale price and the total debt owed is known as a deficiency balance. This shortfall can occur in a short sale, where the lender agrees to a sale price insufficient to cover the loan, or after a foreclosure auction, if the property’s sale proceeds do not fully satisfy the mortgage debt. The deficiency balance typically includes the remaining principal, accrued interest, and any costs incurred by the lender during the sale or foreclosure process.

The legal principle behind a deficiency balance means that the borrower may still owe this remaining amount to the lender even after losing the property. For instance, if a home sells for $150,000 but the outstanding mortgage was $200,000, a $50,000 deficiency balance would exist. The lender may then pursue collection of this amount from the former homeowner.

Laws regarding deficiency judgments, which are court orders allowing lenders to collect this remaining debt, vary significantly across different states. Some states have “anti-deficiency” laws that protect borrowers from being pursued for the deficiency balance, especially for “purchase-money” mortgages on primary residences. In these states, the loan is considered “non-recourse,” meaning the lender’s recovery is limited to the property itself. Other states permit lenders to seek a deficiency judgment, potentially allowing them to pursue the borrower’s other assets or income to satisfy the debt.

Impact on Your Credit

Selling a house for less than the mortgage balance, whether through a short sale or foreclosure, significantly impacts an individual’s credit report and score. Both actions are considered negative marks that can reduce credit scores. While both are detrimental, a foreclosure generally leads to a more severe and prolonged negative impact on credit compared to a short sale.

A foreclosure often begins after multiple missed mortgage payments, with each delinquency further damaging the credit score before the foreclosure itself is reported. Foreclosures typically remain on a credit report for up to seven years, making it challenging to secure new loans or credit during this period. Conversely, a short sale, if executed without missing payments, might be reported as “settled for less than the full amount,” resulting in a less severe credit score drop.

The way the deficiency itself is reported can also affect credit. If the lender pursues a deficiency judgment or reports the balance as a collection account, it adds another negative entry to the credit report. While a short sale generally allows for a quicker credit recovery, both short sales and foreclosures have long-term impacts. Lenders often view a short sale more favorably than a foreclosure because it indicates a proactive effort by the homeowner to resolve financial difficulties.

Tax Consequences of Debt Forgiveness

If a lender forgives or cancels all or part of a deficiency balance, the canceled amount is generally considered taxable income by the Internal Revenue Service (IRS). This canceled debt is typically reported to the taxpayer and the IRS on Form 1099-C, Cancellation of Debt, when the amount is $600 or more. The IRS considers this an economic benefit to the debtor, and therefore, it must be reported on the taxpayer’s federal income tax return.

Several exceptions and exclusions can prevent canceled debt from being taxed. One common exclusion is the insolvency exclusion, which applies if the taxpayer’s total liabilities exceed the fair market value of their assets immediately before the debt cancellation. The amount of canceled debt excluded under this rule is limited to the extent of the taxpayer’s insolvency. For example, if $10,000 of debt is canceled but the taxpayer is only insolvent by $7,000, only $7,000 can be excluded, leaving $3,000 as taxable income.

Another significant exclusion is for qualified principal residence indebtedness. This exclusion allows taxpayers to exclude income from debt discharged on their main home, typically due to a decline in the home’s value or the taxpayer’s financial condition. This relief was notably provided by the Mortgage Forgiveness Debt Relief Act. For debt discharged before January 1, 2026, this exclusion has a maximum amount of $750,000, or $375,000 if married filing separately. Taxpayers claiming an exclusion must file IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, with their tax return to report the excluded amount. Given the complexities, consulting a tax professional is advisable to determine specific tax liabilities and applicable exclusions.

Resolving the Deficiency

After a property is sold for less than the mortgage, addressing the remaining deficiency balance involves several potential mechanisms. Lenders may pursue a deficiency judgment through legal action. This legal process can result in the lender garnishing wages, placing liens on other assets, or levying bank accounts to satisfy the debt, depending on state laws.

Borrowers can also attempt to negotiate directly with the lender to resolve the deficiency. This might involve settling the debt for a reduced amount or establishing a manageable payment plan. Lenders may be open to negotiation, particularly if they believe it is more cost-effective than pursuing a lengthy legal process.

Bankruptcy presents another avenue for resolving a deficiency balance. Chapter 7 bankruptcy can discharge certain unsecured debts, including deficiency judgments, providing a fresh financial start. Chapter 13 bankruptcy allows for a repayment plan over several years. Filing for bankruptcy has its own implications for credit and future financial activities, but it can eliminate the obligation to pay the deficiency.

Understanding state laws is important, as they dictate the specific protections and obligations regarding deficiency judgments. Seeking legal counsel is recommended to navigate these complexities and determine the best course of action.