The answer to this question can be complicated and we recommend that you consult with a tax professional regarding the tax implications for your particular circumstances. As a general rule, any time secured debt over $600 is forgiven or cancelled after a foreclosure (unless debt is non-recourse) or a short sale, the lender must issue to the borrower and the IRS a Form 1099-C that reports the amount of cancelled debt.

In general, cancelled debt is treated as taxable income to the borrower.  However, the federal government has enacted the Mortgage Forgiveness Debt Relief Act of 2007, which exempts from federal tax up to $2 million (married/joint filing) in cancelled debt if it was used to buy, build, or substantially improve a borrower’s principal residence. This law stays in effect through the end of 2012. The State of California has also enacted partially conforming legislation for state income taxes through the end of 2012 as well. The Conformity Act of 2010 limits the qualified principal residence indebtedness to $800,000 (married/joint filing) with an exemption for cancelled debt taxation of up to $500,000.