In the past a short sale would have generated taxable income based on the amount the sale proceeds were short of what was owed (ie the deficiency).  The IRS treated forgiven debt as taxable income, subject to regular income tax.  The good news is that there are some exceptions for the next 2 years. Pursuant to something called "The Mortgage Debt Relief Act of 2007", taxpayers are generally allowed to exclude income from the discharge of debt on their principal residence. Under the Act debt that is reduced through a mortgage restructuring or mortgage debt that is  forgiven in connection with a foreclosure, will qualify for this relief.  The Act applies to debt forgiven through years 2007-2012. Eligible for this exclusion is forgiven debt up to $2 million ($1 million if married filing separately).  However, the exclusion doesn't apply if the discharge is for services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.  Here is a link to the IRS site that will give this information to you in further details:  http://www.irs.gov/individuals/article/0,,id=179414,00.htmlAt this point, you should consult directly with an accountant in your area for further advice.