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Sellers looking to Short Sell their homes have a tax free exemption only until the end of the year making 2012 THE year of the short sale.

Have you considered doing a short sale? If so, you may want to start taking action now. Back in 2007, Congress passed the Mortgage Debt Forgiveness Act. Part of this piece of legislation allowed for a tax exemption for primary-home owners who were doing a short sale and thus experiencing a forgiveness or cancellation of debt.
Usually when a homeowner did a short sale before this act was passed, the actual amount of debt forgiven would be subject to income tax. For example, if a homeowner had a loan for 0,000 and then sold the home in a short sale for 0,000, then that homeowner would need to pay income tax on the 0,000 of forgiven debt. This is literally kicking someone when they are already down, as the majority of people going through a short sale are already in financial straits and the last thing they need is to pay taxes on the debt forgiven. In most cases homeowners would be hard-pressed to come up with this money in the first place.
The Mortgage Debt Forgiveness Act allows a homeowner of a home that was their primary residence to be EXEMPT from paying income tax on forgiven debt. This piece of the legislation is set to expire at the end of this year, barring any extension by the federal government.
It is important to note that this exclusion benefit does not apply to investor or 2nd home/vacation homeowners, and only applies to primary residence owners.
This act essentially saves tens of thousands of dollars for the typical troubled homeowner going through a short sale or distress sale. It allows for incentive for these homeowners to go through with the sale and get an otherwise underwater home revalued and sold for a new buyer looking to be a new steward of that home; this needs to happen in order for the overall market to improve. There are hundreds of thousands of homeowners throughout the country that have gone through this process and benefitted dramatically by not having to pay taxes after the short sale was completed. Further, this act has been a buffer to keep several homes from going into foreclosure, and by going the way of the short sale, homeowners can realize considerable benefits as well as having the hit on their credit less damaging as compared to a foreclosure.
Information regarding this specific issue can be found on the IRS’s website: http://www.irs.gov/individuals/article/0,,id=179414,00.html
This is taken directly from the IRS’s site:
What is the Mortgage Forgiveness Debt Relief Act of 2007?
The Mortgage Forgiveness Debt Relief Act of 2007 was enacted on December 20, 2007 (see News Release IR-2008-17). Generally, the Act allows exclusion of income realized as a result of modification of the terms of the mortgage, or foreclosure on your principal residence.

What does exclusion of income mean?
Normally, debt that is forgiven or cancelled by a lender must be included as income on your tax return and is taxable. But the Mortgage Forgiveness Debt Relief Act allows you to exclude certain cancelled debt on your principal residence from income. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.

Does the Mortgage Forgiveness Debt Relief Act apply to all forgiven or cancelled debts?
No. The Act applies only to forgiven or cancelled debt used to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes. In addition, the debt must be secured by the home. This is known as qualified principal residence indebtedness. The maximum amount you can treat as qualified principal residence indebtedness is million or million if married filing
separately.

Does the Mortgage Forgiveness Debt Relief Act apply to debt incurred to refinance a home?
Debt used to refinance your home qualifies for this exclusion, but only to the extent that the principal balance of the old mortgage, immediately before the refinancing, would have qualified. For more information, including an example, see Publication 4681.
If you are a home owner and you are considering doing a short sale, its in your best interest to get in touch with a local REALTOR professional that specializes in doing short sale negotiations. Many consumers would be surprised to know that the majority of agents in the marketplace are ill suited and uneducated as to the specific intricacies and nuances with regards to the short sale process. A short sale is a much more complex, difficult and time-consuming transaction compared to your standard “equity” sale. As a result, many agents have stayed away from these types of sales because they take longer to close and are more complex in nature.
Nevertheless, distress sales account for nearly 50{297c5c6b3ea17e3fbdea31491536c8876720203ac47d87d9888529190191d255} of all the real estate transactions in many of the largest metropolitan areas throughout the country, so sooner or later, most agents will be involved in a short sale transaction, but if you are considering doing a short sale for your own home, make sure that your agent closes several short sales each year (more than 15) and does the negotiations themselves (which is important because otherwise the agent would be using the services of another professional which means this could cost more money and you are getting updates on the progress on the transaction through your agent and not the story right from the horse’s mouth so-to-speak).
When embarking down the path of doing a short sale on your home, you want to have patience, understanding and earnestness. The banks are getting faster at processing these files, but they are still taking a while to get things done on their end. They make you wait and when they finally get to your file they want you to act without haste, which is seen many times as unfair. Regardless, be ready for this and have patience and when the time to act arrives, make sure you act quickly and in accordance with your agent’s recommendations and the wishes of the bank. You will always want to have a CPA and a real estate attorney to help advise you with any tax or legal issues or implications, as doing a short sale will affect you and have tax and legal consequences. Since your real estate professional is neither a lawyer, nor a CPA, its important to have these professionals on hand in the event they are needed.
Most short sales get approved, most of the time. On average, the bank will net more by doing a short sale over foreclosing on the home. So be positive, and know that there is a good chance the file will be approved and you can work to close on the property and move on with your life. Most people can expect to be able to purchase again within 2-3 years as opposed to 7+ years with a foreclosure.
In many cases, your tax or legal professional will advise that the short sale is the best way to go. 2012 is a poignant year for short sales based on the advantageous tax exemption offered through the Mortgage Debt Forgiveness Act. If this is something that you have considered, engage your tax, legal and real estate professional and get started today before you miss out on this opportunity.