In a short sale, homeowners sell their homes at a price less than what they owe and the bank agrees to absorb the loss.

Currently, homeowners do not have to pay federal taxes on the unpaid mortgage debt because of the Mortgage Debt Forgiveness Act.  The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.

Unless the act is extended, it will expire on December 31, 2012.  If the act expires, homeowners who agree to short sales could see their income tax jump significantly because the portion of the unpaid loan balance not covered by the short sale proceeds will be considered taxable income in many cases.

Short sales are often a better alternative than foreclosure. for both homeowners and lenders.  Foreclosures can be costly for banks. They get stuck with legal costs as well as taxes and maintenance expenses. The longer it takes to repossess a home — and it can take years — the more the expenses mount. Short sales can happen quickly.