(Please note that I am not a tax professional and you should seek the advice of a tax professional to answer tax questions.)
Here’s what I do know, and I learned this when I was a teenager working for tips at the local Pizza Hut.
When you make money, you’re responsible to report it to the IRS if your employer does not. That’s right. When they tip you, you’re supposed to report it.
When you borrow money, as in the purchase of a home or a car, a financial institution writes a check to pay for the asset and then retains the deed or title on that asset until you pay it off. If you don’t pay off the entire note, then the part that you don’t pay off, if forgiven, is viewed as income, even if it’s retro-active.
Since short sales involve such large dollar amounts, there’s no way to skirt the issue. If your lender doesn’t issue you a 1099-C (Cancellation of Debt) then you are just as responsible to report the forgiveness as income as the pizza delivery guys is responsible to report his or her tips.
Now, we all know that tips are taxable income, but what about when the bank approves a short sale?
The only answer I can actually give you is that you might be responsible for the income tax based on the forgiveness. You also might be able to write it off in accordance with the Tax Relief Act of 2007, which is expiring, by the way.
All of these are valid questions that you need to consult with your tax guy about, and make sure that you find the right tax advisor as there are plenty of “professionals” out there that don’t operate in the realm of real estate.