Yes, you can sell your house for less than it’s worth, but the discount comes with strings. If the buyer is a family member or a friend, the IRS treats the gap between the sale price and the home’s fair market value as a taxable gift. If you owe more on the mortgage than the sale will bring in, you need your lender’s written approval for a short sale, and the forgiven balance may show up as income on next year’s tax return. The rules differ sharply depending on which situation you’re in, so the first step is knowing which path applies to you.
Selling Below Market Value to Family or a Friend
Federal law treats the price gap on a discounted sale to someone you know as a gift. Sell a $400,000 home to your child for $250,000 and the IRS sees a $150,000 gift. The size of the discount doesn’t matter; selling the same home for $1 would produce a gift of nearly the full value.
For 2026, you can give any one person up to $19,000 in a calendar year without filing a gift tax return.1Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 Anything above that threshold requires IRS Form 709, which reports the gift and draws down your lifetime exemption. If you and your spouse both own the home, each of you can apply a separate $19,000 exclusion to the same buyer, sheltering $38,000 of the discount without a return.
The 2026 lifetime gift and estate tax exemption is $15,000,000 per person, so most sellers won’t owe actual gift tax.2Office of the Law Revision Counsel. 26 U.S. Code 2010 – Unified Credit Against Estate Tax You still have to file Form 709 whenever a gift to one person tops $19,000, because that filing tracks how much of your lifetime exemption you’ve used. The IRS pays particular attention to below-market sales between relatives, since the transferred equity needs to be factored into the seller’s eventual estate.3Internal Revenue Service. Frequently Asked Questions on Gift Taxes
Capital Gains, Losses, and the Buyer’s Basis
A discount doesn’t erase your capital gains exposure on the portion you did sell. Federal law lets you exclude up to $250,000 in profit from the sale of a primary residence, or $500,000 for married couples filing jointly, provided you owned and lived in the home for at least two of the five years before the sale.4Office of the Law Revision Counsel. 26 USC 121 – Exclusion of Gain From Sale of Principal Residence Any profit above the exclusion is taxable, even on a discounted sale.
If your discounted sale actually produces a loss on paper and the buyer is a close relative, you cannot deduct that loss. Federal law disallows capital loss deductions on sales between close relatives, including spouses, siblings, parents, children, and other lineal descendants.5Office of the Law Revision Counsel. 26 U.S. Code 267 – Losses, Expenses, and Interest With Respect to Transactions Between Related Taxpayers If the buyer later sells at a gain, that gain is taxable only to the extent it exceeds the loss you weren’t allowed to deduct.
The buyer’s cost basis follows its own rule. Rather than starting with the discounted price they paid, the buyer generally takes over your original cost basis for calculating future gains. If your adjusted basis is higher than the fair market value at the time of the gift, the buyer uses fair market value as their basis when calculating a future loss.6Office of the Law Revision Counsel. 26 U.S. Code 1015 – Basis of Property Acquired by Gifts and Transfers in Trust A professional appraisal at the time of sale locks in the fair market value the IRS will use.
Selling for Less Than You Owe on the Mortgage
If the offer on the table won’t cover what you owe, the sale becomes a short sale, and you cannot set the price on your own. Your lender holds a lien on the property and must formally agree to release it for less than the loan balance.7Fannie Mae. Fact Sheet – What Is a Short Sale The bank orders its own valuation, usually a broker price opinion or a full appraisal, to confirm the sale price reflects the market.
Most lenders require an arm’s-length transaction, which means the buyer cannot be a family member, business partner, or anyone with a personal connection to you. Fannie Mae’s standard short sale affidavit requires both sides to confirm the parties are unrelated and unaffiliated.8Fannie Mae Single Family. Short Sale Affidavit Form Violating this term can unwind the sale and expose you to fraud claims. That also means you cannot combine the two approaches in this article: a discounted sale to a relative is not available when the lender is being asked to accept a loss.
Short sale approvals are slow. Expect anywhere from 30 days to several months, especially if more than one lien sits on the property.9Fannie Mae. Fannie Mae Short Sale
What Happens to the Remaining Debt
After a short sale closes, a gap almost always remains between what the lender received and what you owed. That gap is the deficiency. Whether the lender can chase you for it depends on the terms of the short sale agreement and your state’s laws.
Some lenders waive the deficiency as a condition of approving the sale, releasing you from further obligation. Others reserve the right to seek a deficiency judgment, a court order requiring you to pay the balance. A handful of states prohibit deficiency judgments on certain mortgage loans; most allow them. If your approval letter doesn’t explicitly waive the deficiency, assume the lender can still come after the balance. Get written confirmation that the debt is fully satisfied before you close.
Tax on Forgiven Mortgage Debt
When a lender forgives part of your mortgage, the IRS generally treats the forgiven amount as taxable income. The lender reports it on Form 1099-C, and you include it on your return. On a $300,000 mortgage where the home sells for $220,000 and the lender writes off the $80,000 shortfall, you could owe income tax on the full $80,000.
For short sales completed or agreed to before January 1, 2026, a federal exclusion let homeowners exclude up to $750,000 in forgiven mortgage debt, or $375,000 if married filing separately, when the debt was used to buy, build, or improve a primary residence. That exclusion has expired and does not apply to debt discharged in 2026 or later.10Office of the Law Revision Counsel. 26 USC 108 – Income From Discharge of Indebtedness That’s a significant change for anyone considering a short sale this year.
Two other exclusions may still help. The insolvency exclusion lets you avoid tax on forgiven debt to the extent your total liabilities exceeded the fair market value of all your assets immediately before the cancellation. You calculate insolvency by adding up everything you owe and everything you own, including retirement accounts, at the moment before the discharge. If liabilities exceeded assets by $50,000, you can exclude up to $50,000 of the forgiven debt.11Internal Revenue Service. Publication 4681 – Canceled Debts, Foreclosures, Repossessions, and Abandonments A bankruptcy exclusion also applies when the discharge occurs during a Title 11 case, and it takes priority over the others.
Credit Damage and the Wait for Your Next Mortgage
A short sale stays on your credit report for up to seven years. Drops of 100 to 150 points are common, though the impact depends on your starting score. A short sale is generally less damaging than a foreclosure, especially if you kept making mortgage payments until closing rather than falling months behind.
The bigger obstacle for many sellers is qualifying for a new mortgage. Fannie Mae requires a four-year waiting period from the completion date of a short sale before you can get a new conventional loan. Documented extenuating circumstances, such as a job loss or serious medical event, can cut the waiting period to two years.12Fannie Mae. Significant Derogatory Credit Events – Waiting Periods and Re-Establishing Credit FHA and VA loans set their own waiting periods.
Documents You’ll Need
Both paths require paperwork, but the contents look different.
For a Below-Market Sale to Family or a Friend
Start with a professional appraisal to establish fair market value; that number is the benchmark for the gift calculation. Then prepare IRS Form 709, which asks for your Social Security number, the buyer’s name and address, a legal description of the property from the current deed, and the value of the gift minus any exclusions.13Internal Revenue Service. Instructions for Form 709 Have your cost basis ready as well, which is generally what you paid for the home plus permanent improvements, because the sale portion may still trigger capital gains tax.
For a Short Sale
Your lender will want a financial package showing you cannot pay the mortgage in full. The core documents:
- A hardship letter explaining the specific circumstance, such as job loss, medical emergency, divorce, disability, or a significant income drop, that makes full payoff impossible.
- Your federal income tax returns for the past two years.
- Recent pay stubs, bank statements, and a detailed list of monthly income and expenses.
- A signed purchase contract from the buyer and the listing agreement.
The lender uses these to compare its short sale recovery against what foreclosure would produce. Incomplete packages are the most common cause of delay, so pull everything together before you list.
Filing Deadlines and Penalties for the Gift Return
If your below-market sale triggers a Form 709 filing, submit it by April 15 of the year after the gift, with the deadline sliding to the next business day if April 15 lands on a weekend or holiday.13Internal Revenue Service. Instructions for Form 709 Extensions are available.
Failing to file carries real penalties. The IRS assesses a late-filing penalty of 5% of the unpaid tax for each month the return is late, up to 25%.14Office of the Law Revision Counsel. 26 U.S. Code 6651 – Failure to File Tax Return or to Pay Tax Even when you owe no gift tax because the gift fits inside your lifetime exemption, the IRS can penalize the failure to file. Reporting the home’s value at 65% or less of actual fair market value is a substantial valuation understatement and brings additional penalties on top.13Internal Revenue Service. Instructions for Form 709
Keep every record tied to the sale, including settlement statements, appraisals, and closing documents. The IRS’s period of limitations is generally three years after filing, but it extends to six years if income is underreported by more than 25%.15Internal Revenue Service. How Long Should I Keep Records Holding records for at least six years gives you a comfortable margin.
Medicaid Consequences You May Not See Coming
Selling below fair market value can create problems if you or your spouse later apply for Medicaid-funded long-term care. Federal law requires states to review asset transfers made during the 60 months before a Medicaid application. Selling for less than fair market value during that window causes Medicaid to treat the uncompensated value, meaning the difference between fair market value and what you received, as a disqualifying transfer.16Social Security Administration. Social Security Act Section 1917
The penalty is a period of ineligibility for long-term care benefits, calculated by dividing the uncompensated value by the average monthly private-pay cost of nursing home care in your area. Give away $100,000 in equity where the average monthly cost is $10,000, and you’re ineligible for Medicaid long-term care coverage for roughly 10 months. Planning a below-market sale more than five years before you expect to need Medicaid avoids the issue, though that timeline is difficult to predict.
Transfer Taxes and Closing Costs
Beyond income and gift taxes, most sales trigger state or local transfer taxes or documentary stamp fees at closing. Rates vary widely and may be based on either the sale price or the fair market value. Some states charge nothing; others add several percent of the transaction value. Ask your closing agent how the transfer tax applies to a below-market sale in your jurisdiction, because some areas calculate it on the higher fair market value rather than the discounted price.
Recording the new deed at the county recorder’s office carries a separate administrative fee, generally between $10 and $50 for the first page plus a per-page charge for additional pages. A professional appraisal, which you’ll need for either path, generally runs $300 to $600 for a single-family home, with variation by property type and location.