A Short Sale Used to Wipe Out the Leftover Mortgage Tax-Free. Since January 1, the Forgiven Part Counts as Income.

If you’re short-selling your house this year, or your lender agrees to knock down the principal you owe, the part they forgive is income. You won’t see a dime of it, and you’ll owe federal tax on it anyway.

That wasn’t true last year. It is now.

The break that quietly ran out

For years, a tax rule shielded homeowners in exactly this spot. If a lender forgave debt on your main home, up to $750,000 of it, you could leave it off your return. The IRS calls it the qualified principal residence indebtedness exclusion. Everyone else called it the reason a short sale didn’t come with a tax bill.

It covered discharges before January 1, 2026. Congress let it lapse.

IRS Publication 4681 now says it flatly: that debt “cannot be excluded from income for discharges completed or discharge agreements entered into after December 31, 2025.” A House bill to make the break permanent, H.R. 917, was introduced in February 2025. GovTrack shows no action since.

The timing is bad. ICE counted 37,000 foreclosure starts in August, up 29% from a year earlier. Seriously delinquent loans hit 574,000, up 19%.

What it costs you

Say you owe $310,000, the house short-sells for enough to cover $275,000, and the lender writes off the last $35,000. That $35,000 lands on your return as ordinary income. In a 22% federal bracket, that’s about $7,700. In a 12% bracket, it’s $4,200.

You’ll get a Form 1099-C for it. Pub 4681 says you have to report the canceled debt even if the form never shows up.

Here’s what they don’t tell you at the closing table. A short sale feels like the end of the debt. For your taxes, it’s the start.

The exits that still work

First, insolvency. If your debts were bigger than everything you owned right before the forgiveness, you can exclude the canceled amount up to that gap. You claim it on Form 982. Here’s the catch: the IRS worksheet counts your 401(k), your IRA and the cash value of any life insurance as assets. A decent retirement balance can make you solvent on paper while you’re losing the house.

Second, paperwork dated 2025. IRS Topic 431 still protects debt “discharged subject to an arrangement that is entered into and evidenced in writing before January 1, 2026.” If you signed the workout or short sale agreement last year, that letter may be worth thousands.

Third, nonrecourse loans. If you aren’t personally liable for the debt, Pub 4681 says a foreclosure doesn’t create canceled-debt income. A principal cut while you keep the house still does.

Do this before you sign

Ask the lender in writing whether it will issue a 1099-C and for how much. Fill out the Pub 4681 insolvency worksheet with numbers from the day before the deal closes, not from memory. Find the date on any agreement you signed in 2025.

Then take all of it to a tax preparer before you sign, not in April. If you’d rather keep the house, a modification that parks principal at the end of the loan instead of forgiving it isn’t canceled debt, so there’s nothing to tax. Run the payment on our mortgage calculator.

Student loan borrowers lost a similar shield this year. We covered that one here.

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