In a short sale, debt forgiveness by the bank may have tax consequences.  Once a debt is totally or partially forgiven, the amount forgiven will considered as income by the IRS.  Thus, banks report such income to the IRS and issue a 1099-C in the amount of the debt cancelled.Does an individual owe taxes on such cancelled debt???  Maybe…

A. Principal residence:
If the taxpayer purchased the house as a principal residence, any taxes owed on the cancelled debt can be written off as per the new law signed by Bush, subject to some caps. (See Mortgage Debt Reduction Act)

B. Second home or investment property:
The cancelled debt reflected on the 1099-C will be considered ordinary income, and thus any capital loss the individual has incurred cannot be used to offset such ordinary income.  Except that the individual may use up to $3,000 of the capital loss to offset the ordinary income, and any unused capital loss may be carried over to subsequent years, but the taxpayer will have to pay the taxes owed upfront, and any carried over capital loss will used in future years to reduce taxes subsequently, never going over the $3,000 cap.

The Exception: Insolvency.
If the taxpayer is insolvent at the time the debt was cancelled, the taxpayer can reduce the ordinary income from the cancelled debt by the amount the taxpayer was insolvent at the time of the cancellation. 

See 26 U.S.C. Sec 108 (a) (1) (B), and (a) (3), which states that “Insolvency exclusion limited to amount of insolvency: In the case of a discharge to which paragraph (1)(B) applies, the amount excluded under paragraph (1)(B) shall not exceed the amount by which the taxpayer is insolvent.”