When a borrower takes out a loan to purchase a property and is forced to sell that property for less than the principal loan amount that deficiency is referred to as phantom income. For example, if a borrower secures a $150,000 loan to purchase a home and later that property is sold for $100,000 in a short sale or foreclosure auction, the borrower could have phantom income of $50,000. That is assuming the lender “forgives” the borrower’s debt. That $50,000 could count as “income” on the borrower’s tax return!
The IRS maintains if a borrower is protected by Arizona’s anti-deficiency statutes the borrower is not personally liable for the loan debt. Conversely, if the property is not protected by the anti-deficiency statutes the loan debt is recourse (i.e. the borrower is liable for the debt) and the borrower would have to pay taxes on the phantom income. If the property is the borrower’s primary residence, the borrower can be shielded from the COI (cancellation of indebtedness) as a result of a short sale or foreclosure up to the IRS limits ($2 million for married couples and $1 million for single filers or married couples filing separately.)