Video: Guide to Short Sales, Foreclosures and Your Taxes

Hello, I'm Scott from TurboTax with some information for homeowners who experience a foreclosure or short sale.

If you are like most people, the purchase of a home is probably one of the biggest financial decisions you will ever make. But sometimes, circumstances beyond your control may require you to sell the home in a short sale or cause you to lose your house to foreclosure.

And although the last thing on your mind is the tax consequences, it's something you may need to consider when you file your tax return. But luckily, the government provides some tax relief when you lose your home. 

Generally, the IRS treats any cancellation or forgiveness of debt by your creditors as taxable income.

When you short-sale your home, usually your mortgage lender is essentially allowing you to sell the home for less than your outstanding debt and cancels your obligation to repay the difference.

A similar situation occurs when the bank forecloses on your home, but this depends on whether your mortgage agreement requires you to pay off the difference between the value of your home and your outstanding loan balance.

If you aren't liable for any debt beyond what your home is worth at the time of foreclosure, meaning the bank can take your home but nothing more, you will not owe any tax on the remaining debt. However, if you are personally liable for the remaining debt and the bank cancels your obligation to repay it, you have cancelled debt that might be taxable.

Regardless of whether the cancellation relates to a short sale or foreclosure, the current tax law through 2012 allows you to exclude up to $2 million of it from your taxable income if the property was your main home. 

Aside from the tax implications of including the cancelled debt in your income, the IRS also requires you to calculate a capital gain or loss since it treats a foreclosure or short sale as a regular sale. However, you might still be eligible to exclude up to $250,000 of gain, or $500,000 if married and filing a joint return, if you owned the home, and it was your principal residence for two of the last five years.

So for most taxpayers, there is plenty of opportunity to avoid paying additional tax when you experience a foreclosure or short sale. However, this tax savings is not available for your second or rental homes.

When you use TurboTax, we'll ask you simple questions and determine the tax implications of your foreclosure or short sale.