Contrary to popular belief, the deficiencies (deficiency balances) created by both short sales and foreclosures are treated as debt forgiveness by the lenders and, more importantly, by the IRS. Debt forgiveness is essentially a form of income (debt cancellation income) that may create income tax liability unless the borrowers qualify to exempt that income from taxation.
Under the Mortgage Forgiveness Debt Relief Act (only effective through 2016) you can exclude canceled debt from income if it is qualified principal residence indebtedness. Qualified principal residence indebtedness is any mortgage you took out to buy, build, or substantially improve you main home. It also must be secured by your main home. Qualified principal residence indebtedness also includes any debt secured by your main home that you used to refinance a mortgage you took out to buy, build, or substantially improve your main homes, but only up to the amount of the old mortgage principal just before the refinancing.
Don’t let the fear of debt cancellation income discourage you from trying a short sale. Remember that even if you have to pay taxes on the canceled debt it is less than paying back the debt. You should consult a CPA or tax advisor to help you limit any potential tax liability.