When your lender agrees to a short sale of your home it is agreeing to cancel a debt.  The IRS in the past considered your lender forgiving a debt a taxable event. But, because of the real estate meltdown Congress passed the Mortgage Forgiveness Debt Relief Act of 2007 which expires on December 31, 2012.  Most notably, The Debt Relief Act provides an exemption for any debt canceled by the lender which was used “to buy, build or substantially improve your principal residence“. What this means is there will be no tax consequence if there are certain conditions that are met.  Most importantly the debt canceled by the lender must have been used “to buy, build or substantially improve your principal residence.” So if you were like millions of Americans that refinanced your home to pay off bills, send your kids to college or take a trip, and the bank agrees cancel that debt in a short sale you will not be eligible for tax relief.  Additionally the home must be your primary residence. So if you are short selling a second home you will not be eligible for the tax exemption. 

If you qualify the IRS will forgive taxes up to 2 million dollars.

California has a similar program effective for taxable years 2009 through 2012, the maximum qualified principal residence indebtedness eligible for relief is $400,000 for taxpayers who file as married or registered domestic partners filing a separate return and $800,000 for taxpayers who file joint returns, single persons, head of household and qualifying widow or widower (other individual taxpayers).

If you are considering a short sale of your home be to speak to an attorney or tax specialist to make sure the exemptions apply to your sale.