Short sale sellers and their agents have plenty to think about, and it is understandable if they are annoyed by the reams of paperwork that may come their way. Nonetheless, it really is important not only to pay attention to what is in the paperwork but also to be sure to retain it for possible future use. This is because of bad consequences that the seller may experience after the sale has taken place.
Bad enough that a short sale involves the loss of one's home with no equity to show for it, and a credit negative that may last for years; it also has the potential to produce two very bad after-effects. One is that the lender, or the lender's assignee, may continue to pursue the beleaguered seller for the remainder of the debt. The other is that the I.R.S. may come knocking on the seller's door, seeking tax on the amount of debt that was unpaid.
The first possibility is often contained in the paperwork that goes along with the seller's ok of the short sale. The borrower may be required to sign a promissory note for the difference between the debt owed and the short sale proceeds received by the lender. Or, a lender may require the borrower to sign a paper acknowledging that the lender reserves its right to pursue the borrower for this amount.
The second possibility resides in the fact that, if a debt is forgiven, the borrower may be taxed on the amount he didn't have to pay back. (see I.R.S. publication 4681). To be sure, there may be short sales where the debt that is unpaid is not taxable. For those exemptions, see a tax accountant.
The point here is that the short-sale seller may suffer one of those unpleasant consequences; but he ought not to suffer both.
The point is raised because here is what can happen: In allowing the short sale, the bank requires the borrower to sign a note for the difference, or to acknowledge that the bank has the right to take action to collect that amount. Also, probably sometime later, the bank sends out a 1099-C, informing the I.R.S. that a certain amount of debt had been cancelled.
Any one who has dealt with a short sale would raise the question: "How could this happen? The two actions contradict each other!" That is because anyone who has been through the process knows that it is common for the right hand of the bank not to know what the left hand is doing.
This is why it is important for the seller to be sure to keep his paperwork. If he signed a document to the effect that the bank was going to pursue its unpaid interest, he should hang on to that. Then, if he receives a 1099-C saying that the debt was forgiven (and, therefore, taxable), he will have support for the claim that the 1099-C is incorrect.
Conversely, suppose that there was no specific release of the debt and that the paperwork contained no reference to it. Then, if the seller receives a 1099-C, saying the debt was cancelled, he should keep that, just in case the bank, or its assignee, comes calling a year or so later, trying to collect the debt.
None of what has been said here should be construed as tax or legal advice. I am not certified to do that. What I do hope is this little piece will encourage short sale sellers to consult with their appropriate advisors about these matters.
All The Best,