Every situation is different for each person, so it is important to consult with a tax professional, CPA, tax attorney or someone who is qualified to make this determination for you. But here is some information to get you started, after which you should confer with a CPA to see if any of this applies to you. When you do a short sale or a foreclosure the lender is allowed to write off the loss and pass it on to you as income in the form of a 1099-C. The IRS considers this income for you and is taxable. For example, you borrowed $200,000 to purchase a home, but only were able to repay $150,000 in the short sale, you will receive a 1099-C for that $50,000 and possibly taxed on that according to your tax bracket.
Federal Taxes: The Home Mortgage Forgiveness Debt Relief Act of 2007 states if the property is your primary residence and the debt discharged was from your original “purchase money” loan, and then you will not have to pay the taxes for that amount. Further, if you did refinance and used the money to only improve your home, then you may be eligible for exclusion of the taxes as well. This act has been extended until the end of 2012. Find up to date information on this exemption and its rules at the IRS website
If you refinanced your home and pulled the money out for other expenses or it is not your primary residence, then it is possible that you may have to pay the taxes unless you are eligible for “insolvency.”
The IRS does not require you to pay taxes on the loss the lender takes in a short sale if, at the time of the short sale, you are insolvent. Insolvency means your debts (including your mortgage) exceed the value of all your assets. In other words, if, at the time of the short sale, your debt is greater than your assets, then you are insolvent. Ask your tax advisor if you are eligible for the Debt Relief Act qualifications or are eligible for “insolvency” and filing the IRS Form 982.
State Taxes: The state of California conformed to the federal tax exemption (Home Mortgage Forgiveness Debt Relief Act of 2007) with its own senate bill 401 but it does have some differences. Ask your tax adviser if you qualify for an exemption of the state taxes for a short sale. The State of CA also has an insolvency exclusion to ask your tax advisor about.
It is important to understand tax implications can apply whether you do a short sale, deed in lieu or a foreclosure.