When the housing crisis started, congress passed the Mortgage Forgiveness Debt Relief Act. This law exempted from taxation the forgiveness of debt incurred to buy, build, or substantially improve a principal residence. Without this law, the homeowner would pay taxes on amount of forgiven debt in a short sale transaction. This rule also applies to debt forgiven in loan modifications and foreclosures when deficiency is waived or not sought. It’s called cancellation of debt and the IRS considers it a taxable transaction. As the IRS sees it, you have achieved income by borrowing money that you did not have to pay back. That is taxable income according to them. (Never mind that that “income” used to buy a home evaporated into thin air when the real estate bubble popped.) The Mortgage Forgiveness Debt Relief Act exempts from taxation forgiveness of debt on your principal residence for up to $2,000,000 for joint filers. So with this law in effect, you will not pay taxes on the forgiven debt in a short sale transaction on your Orlando home.
When the law was passed, it was scheduled to automatically expire on December 31, 2012. No one knows if Congress will extend the benefits of this law. Many believe it will not. Much probably depends on who is elected to Congress and the Presidency (guess which party is more likely to help the homeowners?). If Congress does not extend the law, the benefits of a short sale will not include safety from taxes owed after the sale. According to the local real estate professionals I speak with, it can take up to 6 months or longer to complete a short sale. So the time for arranging the short sale is NOW, unless you want to risk having a bigger tax bill in 2013.