Let’s assume Linus takes out a $50,000 mortgage to buy a house. After moving in, Linus realizes that he no longer afford the mortgage. Linus’s friend, Lola, would like to buy the house but she can only afford to pay $45,000.
The bank, not wishing to acquire another property via foreclosure, may agree to allow Linus to “sell short”. This means that Lola could pay the bank $45,000 purchase the home.
In this case, the bank would suffer a $5,000 loss. In most cases, Linus would have an income tax consequence of $5,000 for the bank’s forgiveness of debt. In some cases, the bank may sue Linus for a deficiency.
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