A short sale occurs when you sale your real estate and the proceeds that you receive from the sale are not adequate to pay off the then existing financing. The amount of loan that is not paid off may be taxable income if you do not meet certain requirements. This shortage is income from debt relief in IRS terms. Below is a description of the methods available to not be taxed on the short payoff of the loan.
If the real estate you are selling is your principal residence, and the loan is the loan that you used to purchase the residence (in CA), then the loan is purchase money and the debt is non-recourse. Therefore, the short payoff is not taxable. Your loan is not a purchase money loan if you refinanced the property, or you added a home equity line of credit, or other form of second on the property. President Bush also signed a bill before leaving office that exempts up to $2,000,000 of debt relief from being taxable on your principal residence.
If you are insolvent at the time of the short sale (Liabilities exceed assets), then the short payoff is not taxable to the extent of the insolvency. The insolvency must be documented. You will need to have a value established for all your assets, and document all the debt that you have.
If you are bankrupt at the time of the short sale, then the short payoff is not taxable. To be bankrupt, you must have actually filed a petition for bankruptcy.
If the debt on the property is non-recourse, then the short payoff is not taxable. Non-recourse means that the borrower is not personally liable for the debt. Purchase money loans as described above are non-recourse in California.