If you are a real estate professional that deals with sellers who are trying to sell their home short than one of the most asked questions you probably get is regarding the tax implications of the short sale. Up until now I haven't had a very good answer or a direction to point a homeowner regarding this topic. But now I do and so do you.
The Internal Revenue Service publication that handles this exact situation is Publication 4681. The name of it is Cancelled Debts, Foreclosures, Repossessions and Abandonments. Although it doesn't say short sales, a short sale is a cancelled debt.
In a short sale of a house, the cancelled debt is the difference between what is owed and what the bank gets at settlement. When the bank agrees to this loss and the homeowner does not have to repay it, they will almost certainly report the cancelled debt to the IRS. The question is does the homeowner now have to report the cancelled debt as income on their tax return. Prior to 2007, the answer was yes but Congress changed the code and now the answer is a little more complex.
Here is an easy to understand explanation of what the publication says:
If the loans were the original loans on the property and the house is your primary residence, you do not have to claim the cancelled debt as income.
If you refinance the loans and used any excess money to improve the home (and you can prove it) than you do not have to claim the difference as income.
If you used your house as an ATM and took money out to buy a car, vacations, clothes, pay off other credit cards, etc, than you will have to claim the amount that you took out that wasn't used directly to improve the property as income.
If the house is not your primary residence, than you might have to claim it as income but that is much trickier and you should consult an accountant.
This is just an explanation of what the publication says and is not accounting or tax advice and you should always consult a tax professional if you have any questions.
But IRS Publication 4681 is definitely a publication you should consult concerning the tax implications of a short sale.