With a short sale the difference owed in the mortgage balance versus what it sells for is generally taxable income to the seller. For example if a person owes $250,000 on a mortgage and then sells the home $150,000, the bank will give the owner 1099 form from the IRS as income received for the $100,000 difference.
With a foreclosure the seller has a deficency judgment for the difference between the mortgage balance and what the home sells for. In other words, the seller must pay the difference between the mortgage balance and the selling price, rather than just the tax on the on the debt forgiven.
The Mortgage Debt Forgiveness Act of 2007 allows taxpayers to exclude income from cancelled debt on their principal residence. The act applies to debt forgiven during the calendar years 2007 through 2012. Taxpayers are eligible for up to $2 million in exclusions ($1 million if married filing separately).
Forgiven Debt is reported on Form 982 and attached to an individual's tax return.
What is the difference between a short sale and a foreclosure? With a short sale the seller only loses about 100 points off his credit score. With a foreclosure about 250 points are deducted from the seller's credit score.
Another advantage of a short sale versus a foreclosure is that within two years the short-seller has a good chance of getting a mortgage at a decent rate. Foreclosure will adversely affect one's credit score for five to seven years.
Short sales usually take about 30-60 days for the bank to approve the offer and then 30 days to close the property. There are items the bank is going to want from the seller.
In addition, the bank may ask your realtor for "comps" - competitive sale prices for similar homes, and an estimated HUD statement to find out how much of the loan balance will be recovered from the short sale. The lender will also order a "BPO" - broker's price opinion. They will hire another realtor to take a look at the property and estimate its value, a less expensive way to determina value similar to an appraisal.
Note: Some lenders will not grant a short sale unless the owner has defaulted on their loan payments. If you've made all your mortgage payments, the lender may say no! Talk to the lender about it.
When an owner is behind on his mortgage, the worst thing to do is avoid contact with the lender. Also, watch out for "mortgage rescue" companies. They are out to make money and take any equity in your home. Your best bet is to talk with the lender, an accountant or attorney and a realtor. Save your credit and your reputation.