In a short sale, "the lender is accepting less than the total amount due" on the mortgage balance, explains Elizabeth Weintraub, About.com's guide to buying and selling homes. That means, the house is sold for less the balance on the mortgage. The remaining mortgage debt is then forgiven or canceled.
From a tax perspective, a short sale works much the same way that a regular sale would work. The sellers would need to calculate their profit or loss on the sale of the house. Any profit might be excluded from tax treatment. The basic rule is that you can exclude profits of up to $250,000 (or $500,000 if married) as long as you owned and lived in the house for at least 24 months in the five-years ending on the date of sale. Losses on a home are not tax deductible.
The mortgage debt that is forgiven might be taxable income or could be excluded from tax. The rules for handling canceled mortgage debt recently changed. The basic idea is that debt used to buy or build a home (called "acquisition debt") can be excluded from taxable income, but other debt may not qualify for the exclusion.
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