When a short-sale occurs, and a 1099-C is received, is it taxable?
This is a question we sometimes receive. Whether the 1099-C is taxable (or even correct), is a matter of fact and law. California tends to treat mortgages secured by "dwellings", as defined in CA law as nonrecourse debt.
Late 2013, the IRS sent a letter to CA indicating how they will treat cancelled debt resulting from short-sales in CA. Because of anti-deficiency statutes, the debt is nonrecourse meaning the sales price is equal to the debt outstanding, which §121 can apply rendering the occurrence non-taxable. You can see the letter below.
This leaves a few questions, is "bad money" taxable? Is second mortgage debt or refinanced debt taxable?
This depends on CA law on whether it meets the civil procedures to be nonrecourse which is based on real estate law.
This letter is not a formal ruling, however, it does give you indication on how the IRS will treat the sale of the home and the resulting canceled debt. When receiving Form 1099-C for a principal residence, further inquiries may be needed. Sometimes the lender changes and information is missed on the bank's side, which can impact the accuracy of the information on Form 1099-C.