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" (instead of pursuing you for the deficiency balance), you 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 your debt is nonrecourse (you are not personally liable) or recourse (you are 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.
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. You need to check for applicable exclusions in your state. 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.
If the property can no longer be classified as a principal residence, other exclusions may be applicable including qualified real property business, insolvency or bankruptcy.
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