I'm not sure I grasp the question, but I'll make an assumption that could be of help to you or others facing similar circumstances.
The assumption is that the short sale caused a lender to issue a 1099 for debt forgiveness, which may be treated as income (even though no money was actually received – which is why this is often referred to as “phantom income”), creating income tax liability.
If this is the case, a critical question will be when the short sale transaction closed. If it closed on or before 12/31/2012, it is potentially subject to the Mortgage Forgiveness Debt Relief Act of 2007 and generally, if the property was your primary residence and the debt forgiven was your 1st mortgage, you are likely not going to incur any tax liability for the forgiven debt (Note: there are exceptions).
Even if the Mortgage Forgiveness Debt Relief Act of 2007 is not applicable, there is an "insolvency exception" concerning tax liability of cancelled debt which may render an insolvent person's cancelled debt non-taxable (see IRS publication 4681).
That said, let's further assume that you still owe income tax liabilities for 2010, 2011 and you will owe for 2012 . . . what should you do?
1. The first thing to do is to file an honest 2012 return. Stay in compliance. Not only is it the law, filing an honest return is required if, a few years down the road, you are eligible to, and wish to, attempt to discharge tax liabilities in bankruptcy. Additionally, filing a return is required in order for the 10 year statute of limitations for IRS collection begin to toll. Many people feel like they shouldn't file when they owe and they can't pay. WRONG!
2. Prepare a budget; statements of income,expenses, assets and liabilities; re-evaluate your priority of payments to creditors; and organize your financial documents. Are you paying other creditors, like credit cards, before the IRS? Do you have equity in collateralized assets that are subject to burdensome payment obligations? Now is the time to be proactive and conduct a thorough financial analysis of your affairs. Selling assets might allow you to negotiate a lump sum settlement with the IRS and get you out of expensive payments. These are just a couple of examples of the myriad of strategies that an attorney can explore with you.
3. Seek out a competent tax attorney. An attorney can:
a. review your financial documents and budgets with you;
b. assist you in developing a comprehensive strategy to deal with your tax liabilities
c. negotiate an installment agreement, offer-in-compromise, or both (if appropriate) or attempt to have your account placed in a temporarily non-collectible status with the IRS;
d. advise you regarding the Mortgage Forgiveness Debt Relief Act of 2007, the insolvency exception, and other applicable laws; and
e. refer you to a bankruptcy lawyer if bankruptcy is a viable option (although bankruptcy will not yet discharge 2010, 2011 or 2012 tax liabilities, bankruptcy does stay IRS collection and may afford a debtor the opportunity to discharge other debt so as to be able to repay tax liabilities. Chapter 11 or 13 bankruptcy may also assist a debtor in restructuring tax debt into affordable monthly payments while discharging other unsecured debt).
Bottom line – don’t try and hide from the IRS. Hire a competent attorney to represent you. Send me a comment the morning after you’ve hired him or her and let me know how you slept . . . my guess is it’ll be the best night’s sleep you've had in years.
All the best . . .
Colorado practice limited to bankruptcy, federal tax law and related laws under U.S. statutes before the United States Bankruptcy and District Courts for the District of Colorado. We are a federally designated debt relief agency and help people and companies file for bankruptcy protection under the U.S. Bankruptcy Code.