A short sale works when the homeowner sells the home and gives all the proceeds to the lender, the Federal Trade Commission says. The lender then agrees to not foreclose on the home, and the lender forgives the debt repaid by the sale. The amount forgiven is reported as a partial charge off on the former homeowner's credit report, Bankrate notes.
Another option for a homeowner to seek debt forgiveness is when he is facing foreclosure, he gives his house back to the bank by using a deed in lieu of foreclosure, the Federal Trade Commission says. In exchange for signing the title back over to the bank, the bank forgives the remaining debt owed on the home.
When the debt is forgiven, the former owner must report the debt as income to the IRS, the Federal Trade Commission explains. The Mortgage Forgiveness Debt Relief act of 2007 removes the tax liability for the amount of the reported forgiven debt, even though it's reported as income.
Up to $2 million may be excluded, but if part of the mortgage was sued to pay for other purchases or to consolidate debt, that portion of the loan is not excluded from the former homeowner's taxable income, Bankrate explains.