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If the short sell happens before the end of the year and all of the forgiven debt for the home was acquired for the purchase, construction, or improvement of the home, or refinanced qualifying debt the forgiven debt will be non-taxable. Any home mortgage debt that was used for other purposes or mortgage debt that exceeds 2 million dollars will not qualify for this exclusion
If the short sale happens after the end of the year (and Congress doesn't extend the provision mentioned in the first paragraph) the canceled debt may qualify for a exclusion from income
due to insolvency. To qualify as insolvent, the total balance of all your liabilities
will be greater than the total fair market value of all your assets
. If you are insolvent, your canceled debt income will be excluded from income up to the amount that you are insolvent For example, if your liabilities are 100k and your assets are valued at 50k you will have a 50k insolvency -- any canceled debt below 50k will be excluded from income. See page 6 of this IRS
publication for a worksheet on calculating your insolvency: http://www.irs.gov/pub/irs-pdf/p4681.pdf
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