Short sale
From Wikicpa
A short sale is generally the sale of a stock you do not own. Investors who sell short believe the price of the stock will fall. If the price drops, you can buy the stock at the lower price and make a profit. If the price of the stock rises and you buy it back later at the higher price, you will incur a loss.
When you sell short, your brokerage firm loans you the stock. The stock you borrow comes from either the firm’s own inventory, the margin account of another of the firm’s clients, or another brokerage firm. As with buying stock on margin, you are subject to the margin rules. Other fees and changes may apply. If the stock you borrow pays a dividend, you must pay the dividend to the person or firm making the loan.
Alternative with Real Estate
A personal residence short sale occurs when a property is sold and the lender agrees to accept a discounted payoff where the lender releases the lien that is secured to the property's primary mortgage, upon receipt of less money than is actually owed. This is also known as as a "shorted sale."
- Example: If the unpaid balance of a loan is $150,000 and a property sells for $120,000, under a short sale the lender might accept $120,000 as payment in full on the $150,000 mortgage loan.
Tax implications
The general rules under Internal Revenue Code section 61(a)(12) says that discharge of debt income is taxable for Federal income tax purposes for the year the discharge occurs. The lender is required to report the income discharge amount to the borrower and to the Internal Revenue Service on Form 1099-C (Cancellation of Debt). Discharge of debt income does not qualify for the Section 121 home sale gain exclusion. However, Internal Revenue Code section 108 provides some exceptions to the general rule that discharge of debt income is taxable
- Bankruptcy: If the borrower is in bankruptcy proceedings when the discharge occurs, it is entirely excluded from Federal income taxes
- Principal residence mortgage exception: Under this exception, an individual taxpayer can exclude up to $2 million of discharge income from a "qualified principal residence" which means debt used to acquire, build, or improve the taxpayer's principal residence and is secured by that residence This exception is not available for a home equity loan that was not used to improve the residence or from a vacation home mortgage.
- Insolvency exception: If the borrower is insolvent. Defined as having debts in excess of assets, when a discharge of debt occurs, the discharge is entirely excluded from Federal income taxation as long as the borrower remains insolvent after the discharge. If the discharge causes the taxpayer to become insolvent, then the part of the discharge resulting in the taxpayer's insolvency is taxable and the remaining amount is tax-free.
- Deductible interest exception: To the extent that the discharge is unpaid mortgage interest added to the principal loan balance and then forgiven, that amount is considered tax-free. If the taxpayer had paid the interest it would have been deductible.
