Cancellation of Debt on Short Sale of Real Estate
When a rental home secured by a recourse loan is sold short you incur a loss on the disposition of the rental properties requiring the report of a sale as well as any income from the cancellation of debt. The cancellation of debt income is excluded from gross income to the extent you demonstrate insolvency. If for example you demonstrate insolvency in excess of the debt cancelled, none of the cancellation of debt income is included in gross income. Instead, IRS Form 982 Reduction of Tax Attributes Due to Discharge of Indebtedness but not below zero.
If you do not qualify for cancellation of debt income exclusion, the cancelled debt that is included in gross income is reported on IRS Form 1040, Schedule E, line 3. Attach a statement that explains that the entry reported includes both regular rental income as well as cancellation of debt income.