According to the IRS, forgiven or written-off mortgage debt is the same as taxable income. If you complete a short sale on your property, the difference between the lender’s net and the mortgage balance due is referred to as the deficiency. The lender is required to issue a 1099 if they are writing off the deficiency. This is often referred to as “phantom tax” as you could end up owing taxes for money that you did not actually receive.
However, the Mortgage Debt Relief Act of 2007 provides for certain levels of insulation against the phantom tax, at least in the case of your primary residence. Vacation properties would not qualify under the act. The bad news? Unless extended by Congress, this act will expire at the end of the year. For more, visit: http://www.irs.gov/Individuals/The-Mortgage-Forgiveness-Debt-Relief-Act-and-Debt-Cancellation–