A short sale can generate a tax liability both as ordinary income
and capital gain
. The worksheet in Pub. 544
1-2 (page 5) can be used to determine the tax liability, by simply replacing the term "foreclosure" with the term "short sale" wherever it appears in the worksheet.
Whether or not your loss offsets your gain, depends on the facts and circumstances as calculated by the worksheet. To the extent that the property generates passive losses in excess of $3,000, they can be carried forward. To the extent that you have passive losses from prior years, you can use them against your gain in the year of the short sale.
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