Let’s start with what is a Short Sale?
When a homeowner decides to sell their home, but the home is worth less than they owe on their mortgage (to their Lender), the Lender takes a loss and the homeowner makes $0 on the sale of their home. The loss is negotiated with the Lender by your Realtor
In the year the short sale occurs the Lender shows a loss in their accounting. So in order for them to show a loss, someone has a gain. That someone is the homeowner (Seller). The Seller is issued a 1099-c, this shows income.
Although the Seller didn’t have any income, this 1099c, represents the phantom income.
The next question is how to deal with the 1099-c.
If the home was your primary residence, The Mortgage Forgiveness Debt Relief Act of 2007- IRS Publication 4681, applies to you. You must have lived in the home for 2 out of the last 5 years, it must be your primary residence and it cancels any debt up to $2,000,000. This means you will not have to pay income tax on the 1099-C, the income is then canceled or void.
If the home was an investment property, there is a way around the taxes as well. The first step is to contact your accountant, then see if you can claim technical insolvency. In a nutshell, this means your liabilities outweigh your assets, in the current real estate market, this is easy. You must claim technical insolvency at the time of the short sale and the 1099-c becomes void.
If you are in an Anti-Deficiency State, do not allow your Realtor to tell you this covers short sales, here in Arizona, the statute only includes foreclosures. Follow the above guidelines and consult a tax professional!