A short sale under the amount of debt on the property triggers tax liability for cancellation of indebtedness under both federal and state tax laws. After a short sale, should the lender(s) forgive the debt in excess of the "sale price", your fiance and his former girlfriend will likely trigger income to the extent of debt forgiven and the lender will issue a Form 1099-C to that effect. You need to determine whether the debt is nonrecourse (not personally liable) or recourse (personally liable) because different analyses apply (i.e., Gain/Loss and Cancellation of Debt Income). Note: cancellation of debt income is taxed as ordinary income.
This situation is complicated by the fact that he can not claim the property as his principal residence after leaving. If the property is a principal residence subject to recourse debt, then I.R.C. section 108 federal exclusions for gain from the sale and discharge of acquisitional indebtedness would be applicable to transactions through 2012. However, it's important to note that cash taken out of the property value not used to improve the property is generally not qualified for exclusion and is taxable.
The amount of cancellation of debt income and available exclusions depend upon ownership percentages which may have been impacted by the ex girlfriends payments after your fiance's departure. She may well still qualify for the exclusions, but if the property can no longer be classified as his principal residence, other exclusions may be applicable including qualified real property business, insolvency or bankruptcy. You need to have your fiance meet with a professional tax advisor to review the specific facts involved.
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The debt relief that you are talking about is for those that have debt relief on their primary residence. If this was not his primary residence he is not entitled to the relief. You should have a local attorney review his specific facts to determine is primary residence when the debt was forgiven to make sure he does not qualify. If this relief is not available there are three other possibilities: 1) The debt is non-recourse, 2) He went bankrupt, or 3) he is insolvent.
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