If you are in a Short sale or are contemplating such a transaction make sure that you know the tax consequences first. When you sale a property short this means that you are not repaying the debt on the property in full. As a result you will have cancellation of debt income. The lender in the transaction will provide you with a Form 1099C for the amount of debt cancelled. This income has to be reported on your tax return in the year in which the debt is cancelled.
This will cause you to pay additional income taxes on the debt relieved unless you meet one of the exceptions provided under the Internal Revenue Code. The available exceptions are as follows:
1) For your personal residence the federal government provides you relief of up to $2 million of debt relief.
2) If the debt is non-recourse under your state law it is excluded from income.
3) If you are insolvent (your debts exceed your assets) you can relieve debt to the extent you are insolvent.
4) if you declare bankruptcy the income is excluded.
Youwill need to complete Form 982 on your federal return to claim one of these exemptions. I also suggest that you include and explanatory note along with your return to explain why you are excluding the income from the 1099C from your return.