As part of the fiscal cliff bill passed early this morning, the Mortgage Debt Forgiveness Act (MDFA) was extended for an additional year through 2013. It expired on 12/31/12.
As long as your short sale closes before the end of 2013, and provided the property was your primary residence, there will be no income tax due on the 1099 that is issued after closing.
The same will apply to properties foreclosed in 2013. If the foreclosure is completed in 2013 (sheriff’s sale held and confirmed by the court), then there will be no tax owed on the difference between the market value of the property and the outstanding mortgage amount. This will only help owners of properties already in foreclosure. Since foreclosure takes so long in Illinois (14-20 months), you will have to carefully examine if beginning a strategic default makes sense now makes sense or not, because the law will likely expire again before the foreclosure is completed. And who knows if it will be extended again.