Short sale or deed in lieu in the USA: servicer rules and the tax

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Kooky

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A home that is worth less than the loan secured on it cannot be sold in the ordinary way. At closing the mortgage has to be paid off before the buyer can take clear title, and the sale price does not stretch that far. In the United States two arrangements exist for that situation short of a foreclosure: the short sale, in which the lender accepts less than it is owed, and the deed in lieu of foreclosure, in which the owner hands the property to the lender. Both depend on the lender's consent, and both can leave two questions open long after the keys are gone: whether the unpaid balance is still owed, and whether the part that is forgiven counts as income.

This guide follows the federal sources on each point. The Consumer Financial Protection Bureau (CFPB) defines the two arrangements and publishes Regulation X, the rule that sets out how a mortgage servicer must handle a request for help. The Department of Housing and Urban Development (HUD) describes how the two options are sequenced on loans insured by the Federal Housing Administration. The Internal Revenue Service (IRS) explains when cancelled mortgage debt is taxable, which exclusions remain in 2026, and which forms carry the figures. State law, which decides whether a lender may pursue the unpaid balance, is outside those sources and is flagged wherever it matters.

Regulation X, 12 CFR 1024.41, as published by the CFPB; IRS Instructions for Forms 1099-A and 1099-C, revised April 2025.

What a short sale is

The CFPB defines a short sale as a sale of a home for less than what the owner owes on the mortgage, and classes it as a type of loss mitigation, the general term for arrangements that avoid a foreclosure. Its consumer guidance adds two things that shape everything else. The first is that the owner still has to leave the home: a short sale is an alternative to foreclosure, not a way of staying. The second is that it needs the agreement of the lender or the servicer, the company that collects the payments and manages the loan. If that agreement is given, the CFPB says, the owner may be able to sell the home to pay off the mortgage even though the price or the proceeds are less than the remaining balance.

The owner therefore markets the property as any seller would, with a listing and a buyer, but the party that decides whether the price is acceptable is the one releasing the lien. HUD's description of the option on FHA-insured loans, which it calls a Pre-Foreclosure Sale, puts it the same way: where the market value of the property is not enough to pay the loan in full, the servicer may accept less than the full amount owed from eligible borrowers. HUD adds that relocation expenses may be available if conditions are met; its programme page gives no amount.

What a deed in lieu of foreclosure is

A deed in lieu of foreclosure, in the CFPB's words, is an arrangement in which the owner voluntarily turns over ownership of the home to the lender to avoid the foreclosure process. There is no buyer and no sale on the open market: the deed itself passes to the lender, and in exchange the lender does not foreclose.

On FHA-insured loans, HUD presents the deed in lieu as the step that follows a short sale that did not happen. Its loss mitigation page says the option applies if a Pre-Foreclosure Sale cannot be completed by the end of the marketing period, at which point the borrower may voluntarily offer to deed the property to HUD in exchange for a release from all obligations under the mortgage. The length of the marketing period is not stated on that page. Those terms belong to the FHA programme; the federal pages read for this guide do not set out the conditions that apply to other loans.

The deficiency, and why the waiver matters

Selling short or handing back the deed does not by itself settle the debt. The CFPB defines a deficiency as the difference between the value of the property and the amount still owed on the mortgage loan. Its guidance says that in some states the borrower is responsible for any deficiency, and that in those states the lender could sue to collect it after a short sale. The bureau does not list the states, so the answer depends on the law of the state where the property sits and on the terms of the loan.

For both arrangements the CFPB describes the same safeguard. Before completing a short sale, a borrower in a state where the deficiency can be pursued may ask the lender to waive it; a waiver of deficiency means the lender has given up the right to collect that amount. For a deed in lieu the bureau says the same request can be made. In each case its guidance is to get the waiver in writing and to keep it.

The waiver has a second effect, which the CFPB's deed in lieu page mentions in one line: the borrower may still incur a tax liability. A balance that is waived is a debt that has been cancelled, and the IRS has its own rules for that, covered below. The CFPB also notes that being left responsible for mortgage debt, and having a foreclosure, can affect the ability to buy another home later, and it points borrowers to HUD-approved housing counsellors. HUD's page says foreclosure prevention counselling from those agencies is always free.

Regulation X: what the servicer owes the borrower

A short sale or a deed in lieu is requested through the servicer, and the procedure the servicer must follow is in Regulation X, at 12 CFR 1024.41, headed "Loss mitigation procedures". One sentence of the rule sets its limits. Paragraph (a) says that nothing in the section imposes a duty on a servicer to provide any borrower with any specific loss mitigation option. The rule is about process: how fast an application is acknowledged, how it is evaluated, what the borrower is told, and what the servicer may not do while that is happening. Whether a short sale is approved remains a decision for the servicer and the owner of the loan. The same paragraph says a borrower may enforce the section under section 6(f) of the Real Estate Settlement Procedures Act.

The central term is the complete loss mitigation application. Paragraph (b)(1) defines it as an application for which the servicer has received all the information that the servicer requires from a borrower in evaluating applications for the options available. The servicer decides what that information is, but it must exercise reasonable diligence in obtaining the documents and information needed to complete the file.

Paragraph (b)(2) covers the first exchange. If the servicer receives an application 45 days or more before a foreclosure sale, it must review it promptly for completeness and notify the borrower in writing within 5 days, excluding legal public holidays, Saturdays and Sundays, that it has received the application and whether it is complete or incomplete. Where documents are missing the notice gives a date for sending them. The official comments published with the rule say 30 days after the notice is generally a reasonable date, and that the date should not leave the borrower fewer than 7 days.

A servicer may not use an incomplete file as a way round the main duty. Paragraph (c)(2) says it shall not evade the requirement to evaluate a complete application, although it may offer a short-term payment forbearance programme or a short-term repayment plan on the basis of an incomplete one. The comments describe short-term as forbearance of up to 6 months, or a repayment plan covering up to 3 months of past-due payments repaid over up to 6 months.

The 37-day and 30-day rules, offers and appeals

Once the application is complete, paragraph (c)(1) sets the two figures the rule is best known for. If the servicer receives a complete application more than 37 days before a foreclosure sale, then within 30 days of receiving it the servicer must evaluate the borrower for all loss mitigation options available to the borrower and send a written notice of its determination. The wording is "available": as paragraph (a) makes clear, the rule does not oblige a servicer to offer a short sale or a deed in lieu.

The timing of the application decides how long the borrower has to answer an offer. Under paragraph (e), where the complete application arrived 90 days or more before a foreclosure sale, the servicer may require an acceptance or rejection no earlier than 14 days after it provides the offer. Where it arrived less than 90 days but more than 37 days before a sale, the minimum is 7 days. A servicer may treat an offer as rejected if the borrower has not accepted it by the deadline.

Denials have their own rules. Under paragraph (d), a notice that denies a trial or permanent loan modification must state the specific reason or reasons for the decision on each such option. Paragraph (h) gives a right of appeal against a loan modification denial to a borrower whose complete application reached the servicer 90 days or more before a foreclosure sale. The appeal must be made within 14 days, the servicer must decide it within 30 days of the appeal, and that decision cannot be appealed again.

Two further paragraphs narrow the picture. Under paragraph (i), a servicer need not repeat the whole procedure for a new application if it has already complied for one complete application and the borrower has been delinquent continuously since. Under paragraph (j), a small servicer is subject to the 120-day rule described next, and may not file for foreclosure, seek a judgment or hold a sale while the borrower is performing under a loss mitigation agreement.

When foreclosure must wait

Regulation X limits, at three points, the running of a foreclosure alongside a pending request for help.

1. Before any filing. Under paragraph (f)(1), a servicer may not make the first notice or filing required for a foreclosure unless the mortgage is more than 120 days delinquent. The paragraph carries exceptions, among them a foreclosure based on a due-on-sale clause and a servicer joining the action of another lienholder.
2. Application before the first filing. Under paragraph (f)(2), if a complete application arrives before the first notice or filing, the servicer generally cannot make that filing until one of three things has happened: the borrower has been told no option is available and any appeal has run out, the borrower has rejected every option offered, or the borrower has failed to perform under a loss mitigation agreement.
3. Application after the first filing. Under paragraph (g), if a complete application arrives after the first filing but more than 37 days before a foreclosure sale, the servicer shall not move for a foreclosure judgment or an order of sale, or conduct the sale, unless one of the same three conditions is met.

The third condition is where a short sale meets the rule. The official comments say a borrower is deemed to be performing under an agreement on a short sale during the marketing or listing period. While the home is listed under that agreement, the protection holds. If no approved short sale has closed by the end of the period, the comments allow the servicer to determine that the borrower has failed to perform, and the bar on moving to sale falls away.

Cancelled debt and Form 1099-C

When the sale closes or the deed is recorded and the lender writes off what remains, the tax side begins. IRS Topic 431 states the general rule: cancelled debt is generally taxable, and it is reported on the return for the year in which the cancellation occurred. The topic lists a voluntary transfer of the property to the lender among the events that can produce a cancellation, alongside foreclosure, repossession, abandonment and a mortgage modification.

The lender reports the cancellation on Form 1099-C. According to the IRS instructions for the form, revised in April 2025, a lender must file one for each debtor whose cancelled debt is US$600 or more once an "identifiable event" has occurred, and must do so even if the debtor does not have to report the amount as income. The events are coded A to H in box 6. Code F covers an agreement to cancel a debt for less than full payment, and the instructions give the short sale as an example.

The other boxes hold the figures the seller will need: box 1 the date of the event, box 2 the amount discharged, box 3 any interest included in it, box 4 a description of the debt, box 5 a tick if the debtor was personally liable, and box 7 the fair market value of the property. For a short sale or a deed in lieu the instructions tell the lender to use the appraised value in box 7.

A second form, Form 1099-A, exists for the case where a lender acquires an interest in the property securing a loan, and the instructions treat a voluntary conveyance in lieu of foreclosure like an abandonment for that purpose. It reports the date, the principal outstanding, the fair market value and whether the borrower was personally liable. Where the lender both takes the property and cancels US$600 or more in the same calendar year, the instructions let it file Form 1099-C alone, completing boxes 4, 5 and 7.

The form is not the last word. Topic 431 says that a taxpayer who believes it is wrong should contact the creditor, and must report the correct taxable amount even if the form is inaccurate. It adds that if the creditor is still trying to collect, the debt may not have been cancelled at all.

Recourse or non-recourse: the split that sets the tax

Whether the forgiven balance is income at all depends first on the kind of debt. The IRS calls a debt recourse when the borrower is personally liable for it, and non-recourse when the lender's only remedy is the property. Topic 431 treats the lender taking the property as a sale by the owner, and computes it differently for each.

With recourse debt, the amount realised on that deemed sale is the fair market value of the property. The gain or loss is that value less the owner's adjusted basis, and the cancelled debt above the fair market value is ordinary income unless an exception or exclusion applies. With non-recourse debt, the amount realised is the full amount of the debt, plus any cash and the value of other property received, and no ordinary income arises from the cancellation.

A worked example shows the gap. Assume a home with an adjusted basis of US$310,000, a mortgage balance of US$330,000 and a fair market value of US$290,000 when the owner deeds it to the lender, which cancels the whole balance. These are illustrative figures, not market data.

The same property and the same loan balance produce US$40,000 of ordinary income in one case and a US$20,000 gain in the other. Box 5 of Form 1099-C, the personal liability tick, is where the lender records which of the two cases it is reporting.

The exclusions, and where the main home rule stands in 2026

Topic 431, which the IRS last reviewed on 24 September 2026, lists the cases in which cancelled debt is excluded from income. Three matter to a homeowner.

Bankruptcy. Debt cancelled in a title 11 bankruptcy case is not income. Publication 4681 says the taxpayer must be a debtor under the jurisdiction of the court, and the cancellation must be granted by the court or occur under a plan the court approved.

Insolvency. Debt is excluded to the extent the taxpayer was insolvent. Publication 4681 defines that as total liabilities exceeding the fair market value of all assets immediately before the cancellation, and limits the exclusion to the amount of the insolvency. Taking the recourse case above as a worked example, and assuming the owner's liabilities came to US$400,000 against assets worth US$375,000 just before the cancellation, the insolvency is US$25,000. Of the US$40,000 cancelled, US$25,000 is excluded and US$15,000 remains income.

Qualified principal residence indebtedness. This was the exclusion written for homeowners: a mortgage taken out to buy, build or substantially improve the main home and secured by it, up to US$750,000, or US$375,000 for a married person filing separately, as Publication 4681 puts it. Topic 431 lists it only for debt discharged before 1 January 2026, or discharged under a written arrangement entered into and evidenced in writing before that date. Publication 4681, issued for 2025 returns, says that the exclusion cannot be used for discharges or agreements after 31 December 2025.

On the IRS pages as they stood at the September 2026 review, then, a short sale agreed and closed during 2026 does not qualify under this heading, and a seller in that position is left with the bankruptcy and insolvency exclusions. A discharge that completes in 2026 under an arrangement put in writing before the end of 2025 is the case the wording still covers. The Form 982 instructions carry a note that legislation enacted after their publication may change the position; no such change appears on the pages read for this guide.

Even where the exclusion applies it has edges. Publication 4681 says a refinanced loan counts only up to the principal of the old mortgage just before the refinancing, and that where only part of a loan qualifies, the exclusion covers only the cancelled amount above the part that does not. Its example is a short sale at US$620,000 on a recourse loan of US$735,000, of which US$110,000 had been borrowed for other purposes: of the US$115,000 cancelled, only US$5,000 could be excluded. The exclusion is also unavailable where the debt was cancelled for services performed for the lender, or for a reason not directly related to a fall in the home's value or the owner's financial condition.

Form 982 and reporting the sale itself

An exclusion is claimed, not assumed. Topic 431 says the excluded amount is reported on Form 982, attached to the return for the year of the discharge, and that excluding debt generally comes at the price of reducing "tax attributes" such as loss carryovers and the basis of assets, though not below zero.

Publication 4681 sets out how the grounds relate. A discharge in a title 11 case goes on line 1a, and the main home exclusion does not apply in such a case. An insolvent taxpayer whose main home debt qualifies may elect the insolvency exclusion instead, by ticking line 1b in place of line 1e. The Form 982 instructions list the attributes reduced in sequence, starting with net operating losses and reaching the basis of property fifth. Any cancelled debt that is not excluded goes, for a personal debt, on Schedule 1 of Form 1040; Publication 4681 names line 8c.

The sale itself is a separate entry from the debt. Where the calculation produces a gain, as in the non-recourse case, IRS Topic 701 says up to US$250,000 of gain on a main home can be excluded, or US$500,000 on a joint return, if the ownership and use tests are met: 24 months of each within the 5 years ending on the date of sale. The exclusion is generally unavailable to someone who excluded the gain on another home in the two years before. Topic 701 also says that a seller who receives Form 1099-S, the form that reports the proceeds of a real estate closing, must report the sale even if the whole gain is excludable, and that the reporting is done on Form 8949 and Schedule D. The pages read for this guide do not address how a loss on a main home is treated.

The lender's consent closes the sale. The written waiver, the liability box on the 1099-C and the date of the agreement decide what the seller still owes, and to whom.

Kooky, from Shaka

Kooky edits Agents Estate and builds Shaka, the payment router he made for real estate professionals. One payment comes in, and every agent, agency and party in the deal receives their signed share on closing date.

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