I'm not an accountant or lawyer and this is not tax or legal advice. If you are going to attempt a Short Sale, in addition to hiring a competent Realtor, you should run your situation by an attorney and/or accountant.
However, one of the most common questions in Short Sales is whether or not the Bank is going to report the "forgiven" debt amount to the IRS, and whether or not the IRS will then treat it as income.
The good news is that the "Mortgage Debt Forgiveness Relief Act of 2007" means the IRS won't tax you on it. What is confusing to most is that the bank is likely to report it to the IRS, and that the IRS does see it as income, but now it's a special kind of income that is separated out and NOT taxed.
My layman's understanding of the process is that you need to attach the 1099 the lender provides after the sale which shows the amount of forgiven debt, and you need to file form 982 which essentially cancels it out.
Again, please don't rely on this article... use it to run by an accountant or lawyer. But the punch line is that until 2012 you should be forgiven the debt and NOT be taxed on it if you file correctly with the IRS.
One last piece of advice, make sure your bank doesn't file a deficiency judgement against you requiring you to pay the forgiven debt down the line.
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