J.K. Lasser's Your Income Tax 2013: For Preparing Your 2012 Tax Return

31.9 Foreclosures, Repossessions, Short Sales, and Voluntary Conveyances to Creditors

If you are unable to meet payments on a debt secured by property, the creditor may foreclose on the loan or repossess the property. A foreclosure sale or repossession, including a voluntary return by you of the property to the creditor, is treated as a sale of the property on which you must figure gain or loss. Similarly, if the lender agrees to a “short sale” for less than the outstanding mortgage balance in which it accepts the sales proceeds in satisfaction of the mortgage, you must figure gain or loss. A loss on a principal residence or other personal real estate is not deductible. If you were personally liable on the debt, then in addition to realizing gain or loss on the transfer, you also have debt forgiveness income from the cancellation of the debt to the extent the cancelled debt exceeds the value of the property, unless an exception (11.8) applies. For example, if you were insolvent at the time of the debt discharge, the debt forgiveness is not taxable. In the case of a principal residence, a special exclusion for up to $2 million of forgiven debt (11.8) is allowed through 2012; proposals have been made to extend the exclusion.

Figuring gain or loss and income from cancellation of debt on a foreclosure, short sale, or repossession.

You have gain or loss equal to the difference between your adjusted basis (5.20) in the property and the amount realized on the foreclosure, short sale, ...