Your short sale may have tax consequences. The IRS considers the debt your lender forgave taxable income. This is the difference between what you owed and what your home sold for. The lender will report the income to you on a Form 1099-C, Cancellation of Debt. You must report the taxable income to the IRS on your federal tax return to avoid possible underpayment of tax and other associated penalties.
Check your 1099 for errors. Confirm your lender put the correct amount in box 7, as the number might affect your return. Box 7 contains the fair market value of the property. Check your home appraisal report and recent sales figures for similiar properties in the same neighborhood if you're unsure of the property's market value. Contact your lender for a corrected form if you find an error on the 1099.
Confirm the canceled income debt shown in box 2. You will need the total amount of debt you owed the lender before the short sale. Check your mortgage statements and short sale paperwork for this figure. Subtract the total debt from the fair market value shown in box 7. The result is your canceled debt income and should be around the figure shown in box 2 of the 1099.
Enter the figure in box 2 of your 1099 as "Other income" on your federal tax return form. Find the other income line on the tax form you're using. For the 2012 tax year, for example, line 21 was for reporting other income.
Determine whether you must file a Schedule D, Capital Gains and Losses, to report the gain from the short sale. If your property was your primary home and you owned it for at least two out of the last five years before the short sale, you may qualify for an exclusion of some or all of the gains income. For example, a single filer could exclude $250,000 for the 2012 tax year.
Calculate your gain from the short sale if you must file a Schedule D. Subtract your adjusted basis in the home from its fair market value. The adjusted basis is how much you paid for the home plus the total cost of major improvements you made. The result is your gain. Report the gain on your Schedule D.