The Mortgage Debt Forgiveness Act is set to expire at the end 2012. This act provides tax exemptions to home owners who have a deficiency judgement as the result of a foreclosed or short sale their home. A deficiency judgment is an unsecured money judgment against a borrower whose mortgage foreclosure sale did not produce sufficient funds to pay the underlying promissory note, or loan, in full. The IRS considers this taxable income. For example is a mortgage balance is 100k and and after the home is sold through short sale or foreclosure the total amount recovered after expenses is 50k. The IRS would consider the 50k of debt cancellation as taxable income. The Mortgage Debt Forgiveness Act is an exemption for home owners to not be taxed on forgiven debt, but this is the last year to claim it.
A major benefit of a short sale over a foreclosure is the ability to negotiate the deficiency judgement away. When using an experienced short sale Realtor & attorney they will most likely be able have the bank release the mortgage deficiency and have it reported to your credit scores as "paid in full" or "settled." This has a dramatic difference simply because a foreclosure will not be on the record, which will damage credit for 7-10 years. In effect it's like a fresh start with the slate wiped clean, giving home owners a chance to start over and one day purchase again.
Is Cancellation of Debt income always taxable?
Not always. There are some exceptions. The most common situations when cancellation of debt income is not taxable involve:
Qualified principal residence indebtedness: This is the exception created by the Mortgage Debt Relief Act of 2007 and applies to most homeowners.
Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your total assets.
Certain farm debts: If you incurred the debt directly in operation of a farm, more than half your income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, your cancelled debt is generally not considered taxable income.
Non-recourse loans: A non-recourse loan is a loan for which the lender's only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income. However, it may result in other tax consequences.
More information is available on the IRS website [http://www.irs.gov/individuals/article/0],,id=179414,00.htm