What Happens If You Sell Your House for Less Than You Owe?

Selling a home for less than the amount owed on its mortgage can be a challenging financial situation. Homeowners may face this due to unexpected personal hardship or shifts in the real estate market. When a property’s value declines, or circumstances require a sale below the outstanding loan balance, it raises questions about financial implications and available options. Understanding key financial terms and processes is important for informed decisions.

Understanding the Deficiency

A homeowner is in an “underwater” mortgage situation when the outstanding loan balance exceeds the current market value of their home. For instance, if a home is valued at $200,000 but the mortgage balance is $225,000, the homeowner has $25,000 in negative equity. This scenario can occur if property values decline after the home was purchased or if a large loan was taken out against the home’s value.

When a property sells for less than the amount owed on the mortgage, a “deficiency” arises. This is the difference between the outstanding loan balance and the sale price. For example, if a mortgage balance is $300,000 and the home sells for $250,000, the deficiency is $50,000. This amount remains legally owed to the lender, even after the property is sold.

Implications for Your Financial Standing

Lenders may pursue a “deficiency judgment” to collect the unpaid balance after a property sells for less than the mortgage amount. This court order legally obligates the former homeowner to pay the remaining debt. The ability of a lender to obtain such a judgment varies significantly by jurisdiction and loan type, with some laws limiting or prohibiting them.

If a lender secures a deficiency judgment, they can pursue collection through various means. This includes garnishing wages, levying bank accounts, or placing liens on other assets. The judgment can remain enforceable for many years, with time limits varying by jurisdiction. This outcome can severely impact a homeowner’s financial stability.

Selling a home for less than the amount owed, especially through a short sale or deed in lieu of foreclosure, significantly affects credit standing. These actions are reported to credit bureaus and can lead to a substantial drop in credit scores. The exact score reduction varies by prior credit history, but it can range from 100 to 150 points for a short sale and 50 to 125 points for a deed in lieu.

A negative mark from a short sale or deed in lieu typically remains on a credit report for up to seven years. This can make it difficult to obtain new credit, such as a mortgage, car loans, or personal loans. While these options are often less damaging to credit than a full foreclosure, they still represent a significant financial setback.

Resolving the Outstanding Debt

When facing an underwater mortgage, a “short sale” is an alternative to foreclosure where the lender accepts a sale price less than the outstanding mortgage balance. The process begins with the homeowner demonstrating financial hardship by submitting a detailed hardship package. This package includes a letter explaining difficulties and supporting documents like bank statements, pay stubs, and tax returns. After submitting this, the homeowner lists the property for sale.

Once an offer is received, it is submitted to the lender for review and approval. The lender evaluates the offer, often ordering an appraisal or broker’s price opinion to confirm market value. Short sale negotiation involves determining how the deficiency will be handled. The lender may agree to forgive the deficiency, partially forgive it, or pursue its collection. The closing process requires lender communication and approval.

A “deed in lieu of foreclosure” is another option for homeowners unable to meet mortgage obligations, involving the voluntary transfer of the property title directly to the lender. This arrangement allows the homeowner to avoid the formal foreclosure process, which can be prolonged and publicly recorded. To initiate a deed in lieu, the homeowner submits a loss mitigation package, similar to that for a short sale, to demonstrate financial distress. Lenders consider accepting a deed in lieu if it reduces their financial losses and helps avoid foreclosure expenses, especially if the property is maintained.

Negotiations for a deed in lieu also involve addressing the deficiency. Homeowners can negotiate with the lender for the waiver or reduction of this outstanding amount. Obtain a written agreement from the lender stating how the deficiency will be resolved, whether through full forgiveness or a modified payment plan. While a deed in lieu offers a streamlined exit from homeownership compared to foreclosure, it still has significant credit implications.

Tax Implications

When a lender forgives or cancels all or part of a mortgage deficiency, the forgiven amount may be considered “Cancellation of Debt (COD) income” by the IRS. For example, if a lender forgives $50,000 of debt, that amount could be added to the taxpayer’s gross income. Lenders are typically required to issue Form 1099-C, “Cancellation of Debt,” to both the homeowner and the IRS when $600 or more of debt is forgiven.

Several exceptions and exclusions might prevent COD income from being taxable. One common exclusion applies if the homeowner was “insolvent” when the debt was canceled, meaning their total liabilities exceeded their total assets. In such cases, the amount of debt forgiven up to the extent of insolvency may not be taxable. To claim this exclusion, taxpayers generally file Form 982 with their tax return.

Another important exclusion, the Qualified Principal Residence Indebtedness (QPRI) exclusion, applies to certain debt canceled on a taxpayer’s primary residence. This exclusion typically covers debt incurred to acquire, construct, or substantially improve the principal residence, and it must be secured by that residence. The specific limits and applicability of this exclusion vary by tax year and debt amount, but it provides significant relief for many homeowners. Even if an exclusion applies, the forgiven amount must still be reported to the IRS.