Short sales of real estate are everywhere now. A short sale happens when there are not enough funds to pay the existing mortgage holder, so the seller and the lender agree that the mortgage can be paid short.

After closing, the shorted lender can either:

1. Issue a 1099 to the seller for the amount forgiven (which is then taxable to the seller as ordinary income, unless it was a primary residence).
2. File a deficiency judgment lawsuit against the seller for the unpaid amount (this rarely happens).

This WSJ story discusses how many lenders are asking the seller in a short sale to sign a promissory note for the amount unpaid in a short sale. Then the lender files suit under the note for the unpaid amount. This is happening primarily in cases where the seller has other assets that can be used to pay the shortage and with investment properties.

I have not had a lender ask the seller to sign a note in a short sale. Nor have I seen a seller sued for a deficiency judgment. So far, lenders have 1099’d the seller for the amount unpaid.

The 1099 can cause a cascade of tax problems. The sellers only relief may be to file bankruptcy to get rid the income from this “cancellation of debt.”