As a result of the real estate market we are experiencing, people are losing their homes to foreclosure or even a short sale.  What many do not realize is that there can be significant tax consequences as a result of either of these transactions.  When a property is foreclosed on or sold through a short sale there are two significant tax issues that must be addressed: (1) the taxes associated with potential cancellation of debt income; and (2) the sale or otherwise disposition of the property. 

Many people know that there is tax relief under certain circumstances for cancellation of debt income.  However, they often fail to realize that the disposition is also treated as a sale for income tax purposes and a gain or loss must be calculated.  Determining the taxable amounts relating to the sale of the property and the cancellation of debt income can be a challenge.  It requires financial calculations, a good knowledge of the income tax code and patience and diligence in completing the required income tax forms.

For those who are not aware, the general rule is that cancellation of debt is a taxable event.  Some exceptions to this include bankruptcy, qualified farm indebtedness, insolvency and certain qualified real property business debt.  But under the Mortgage Forgiveness Debt Relief Act of 2007 (enacted in 2007), many taxpayers will be able to exclude qualified principal residence indebtedness if the balance of the mortgage was less than $2 million ($1 million for a married person who files separately).