What possible tax issues might I have with a short sale?

What possible tax issues might I have with a Southwest Florida short sale?

The issue resolves around forgiven debt in the short sale situation. Whenever a debt is forgiven, the creditor will generate a 1099 for the debtor. This is true whether short sale or foreclosure or deed in lieu.
As we disclaim in our Southwest Florida short sale questions and the Southwest Florida short sale blog, every borrower should seek specific tax advice from someone experienced in the very questions that apply to that borrower.

Southwest Florida short sale on your primary residence under IRC Section 121:

The Southwest Florida short sale homeowner can find some basic information on the Mortgage Debt Relief act of 2007 at this IRS link. Generally, the Act allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.
If the loans at issue are purchase money loans in Florida, the seller is not likely to see any 1099 issue at all. Purchase money loans are non-recourse. A 1099 would issue only when the lender has a right to collect in amounts beyond the collateral value.
If the loans at issue represent equity take out loan, the homeowner may avoid a 1099 on the purchase money portion and get a 1099 on the equity portion.

Short sale on Southwest Florida rental property

IRS Form 982 is used to reduce the liability of a tax attributed to the sale of a property that results in a loss. See Section 108 of the IRC. The seller of a rental property needs to be prepared to use this option to avoid tax liability, if any. Section 108 specifically qualifies real estate for business purposes and paves the way for the tax payer to avoid liability for phantom income associated with rental property.

The second home short sale dilemma

The second home presents a true issue with regard to short sale and tax planning. The borrower that needs to go into a short sale on a second home could be well advised to seek tax counsel and explore whether the property might be converted into rental property and qualify under the example above for rental properties under Section 108.

The IRS and cancelled debt

For more information on the IRS and cancelled debt, refer to IRS Publication 4681: Canceled Debts, Foreclosures, Repossessions, and Abandonments - specifically the sections on Qualified Real Property Business Indebtedness and Qualified Principal Residence Indebtedness.