The question is being asked a LOT lately about whether the banks will be reporting the shortfall on the loan (the difference between what the house sells for vs. what is left owing on the 1st and/or 2nd mortgages) as income to the IRS, resulting in a tax bill that could be substantial depending on how much was “shorted” in a short sale with the bank. The “Mortgage Forgiveness Debt Relief Act of 2007” relieves the homeowner of any potential liability in regards to the shortfall if the property is a the owner occupied. In the event that a cash out refi was taken out on a primary residence then you will probably be issued a 1099.
All is not lost on the investment property or second home if the borrower can prove insolvency. The threshold for proving insolvency is much lower than qualifying for bankruptcy. Ask your CPA about IRS form 982.. As a homeowner if you can prove with receipts, etc, that all the cash was only used for the house (updates, repairs, etc) then you may not be liable. Another thing to know is that you cannot be issued a 1099 AND a Deficiency Judgment.