The Mortgage Forgiveness Debt Relief Act of 2007 excludes canceled debts on your personal residence from being classified as income.This special, limited exception was extended through 2012.
Let’s say you negotiate a short sale on your house like this: You owe $100,000 on the loan, but the house is only worth $50,000. You find a buyer for $50,000 and the bank accepts a short sale in the amount of $50,000. Under the old law, you would receive a 1099-C for the $50,000 that was canceled and you would have to pay income tax on that amount. But now – under the new law – that $50,000 can’t be classified as income and you can’t be taxed on it.