Cancellation of Debt Rules
Typically, you shouldn't owe taxes on a short sale thanks to the 2007 Mortgage Forgiveness Debt Relief Act, which was extended through the year 2013. Naturally, this has to be for a primary residence, and the debt should be less than two million dollars if you are filing jointly. Under the law the forgiveness must be related to a decline in the value of your house or your financial condition, so you can't just walk away from a good mortgage, and you probably wouldn't if you could just sell the house for the same amount you paid for it.
When filing taxes on the 1099-C form data, you will normally need to file Form 982 showing that the debt is related to a primary home, not a vacation property, rental property, or cash-out refinancing.
Will People Walk Away From Mortgages?.
The expiration of the short sale provision in 2013, if the law is not extended, leads many to wonder if people will walk away from their homes before the end of the year if this means they can get debt forgiven before they would be liable for tens of thousands of dollars in income taxes.
Foreclosures and Loan Modifications Eligible
Loan modifications and foreclosures will also generate a 1099-C form that has to be filed. For example, if your bank forgave a certain amount of debt on your home, then you would need to file this form and you may have gotten it in the past year showing the amount forgiven as if it was income. A modified loan should show the difference between the original loan amount and the new loan amount, but keep in mind that if the bank kept the amount the same and changed the payments then you would probably not see a 1099C in the same way as you would see one for a short sale.