Tax Consequences of a Short Sale

I am often asked about the tax consequences to the property seller of a 'short sale". I've attached an article from Bill Bichoff, a 25 year CPA and tax columnist for SmartMoney.com.

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Tax Consequences of a Short Sale

It's not so unusual these days to have mortgage debt that exceeds the current value of your principal residence. If you hang on to the property long enough, you have a reasonably good chance of riding out the storm with little or no harm done. On the other hand, if you have to sell now, you face what's called a "short sale" -- which means selling for a net sales price (after subtracting commissions and other closing costs) that's less than the outstanding mortgage debt.
What are the tax consequences of a short sale? The easiest way to explain it is with some examples.
Tax gain on a short sale. Say you paid $200,000 years ago for a principal residence that you could now sell for a net sales price of $300,000. Unfortunately, you also have $350,000 of first and second mortgages against the property because you took out a big home-equity loan a couple of years ago at the top of the market when the home was worth $500,000.
Believe it or not, you'll have a $100,000 gain for tax purposes if you sell. Why? Because the net sales price exceeds the tax basis of the home: $300,000 sales price minus $200,000 basis equals a $100,000 gain. (Your tax basis equals what you paid for the property plus the cost of any improvements made over the years, minus any past depreciation write-offs if you rented the property out or used part of it for deductible business purposes.)
While it doesn't seem fair that you could have a $100,000 tax gain from a sale that leaves you $50,000 in the red with your mortgage lenders, that's the way the law works. Mortgage debts don't enter into the gain-on-sale calculation.
Now for the good news: You'll probably be able to exclude the $100,000 gain for federal income-tax purposes, thanks to the federal home-sale-gain exclusion break. If so, you won't have to report the $100,000 gain on your Form 1040. You may or may not qualify for the same favorable treatment on your state income-tax return.
Tax loss on short sale. Of course, you can also have a short sale where the net sales price is less than your tax basis in the property.
Say you paid $415,000 for a principal residence that you could now sell for a net sales price of $300,000. You also have $350,000 of first and second mortgages against the property. For tax purposes, you'll have a $115,000 loss if you sell because the sales price is lower than your tax basis in the home: $300,000 sales price minus $415,000 basis equals a $115,000 loss. Will the IRS let you claim a write-off for that loss? Nope. You can only claim a federal income tax loss on investment or business property. A loss on a personal residence is considered a nondeductible personal expense. Most states follow the same principle.