Thinking of a short sale? Don't forget to consider your credit score!

Many people with homes underwater (when the market value is less than the amount due on the mortgage) are either walking away from their homes and letting them go to foreclosure or working out a short sale with the bank. A short sale is getting the bank to accept less than the principal due to release you from your mortgage obligation.

One WalletPoper asked how this would impact her credit score:

I tried to sell my overpriced home for over a year, to no avail. I am currently completing a short sale and the mortgage company will let me out of the deal. How will this affect my credit score?

Unless you negotiate something different with the bank, the bank will report the account closed and indicate that the loan was not paid in full. This can have a negative impact on your credit score. But, working with an attorney, you may be able to negotiate how the short sale is reported to the credit reporting agencies. Talk with the attorney handling the short sale and discuss your concerns about your credit score. As part of the short sale terms, he may be able to negotiate with the bank to report the sale as paid as agreed.In addition to your worrying about your credit score, you also will need to know how this sale is being reported to the IRS. When you do a short sale, any money forgiven is seen as income for you. For example, Suppose your mortgage principal is $200,000, but with the short sale you will only repay $150,000. That means $50,000 was forgiven. You may have to pay income taxes on the $50,000, which will be seen by the IRS as income. The bank will send a 1099 showing the amount of debt cancellation.

You should discuss the tax implications of your short sale with your accountant. He may be able to help you structure the deal to minimize the tax hit.

Lita Epstein has written more than 25 books including "The 250 Questions You Should Ask to Avoid Foreclosure" and the "Complete Idiot's Guide to Improving Your Credit Score."