Normally, when a debt is cancelled for less than full payment, this creates a type of income called Debt Discharge Income. A bankruptcy discharge does not have this problem. Surprisingly, even a mortgage foreclosure sale or auto repossession can create possible tax income. Anyone doing a short sale or facing a foreclosure, who has not filed for bankruptcy and gotten their personal liability for the debt discharged there faces this problem. There are some exceptions, but applying them is not simple. The IRS released, in April 2010, Publication 4681, which covers tax year 2009. It provides guidance and some explanations.

You can find it at http://www.irs.gov/pub/irs-pdf/p4681.pdf

Take a look at the examples on page 11. Most importantly, be sure to get qualified tax advice from your accountant.

IRS CIRCULAR 230 DISCLOSURE: Pursuant to Treasury Regulations, any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used or relied upon by you or any other person, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any tax advice addressed herein.