“Short sales” are sale of real estate where the seller does not have enough money to pay off the existing mortgage(s). The lender reduces the amount owed voluntarily. The “forgiveness of debt” is taxable.
However, there is an exception if you sell your primary residence in a short sale and have lived there for at least two years before you sell. In that case, there is no tax due on the forgiveness of debt.
Unfortunately, this rule does not apply to any investment real estate or to second homes. If either of these types of properties are sold in a short sale, the amount of the loan that is “forgiven” is TAXABLE to the seller.