Mortgage short sale is taxable to borrowers

from http://www.orlandosentinel.com/

It's no joke: IRS can tax you if you sell house for a loss
Robert Bruss Inman News
July 29, 2007

Question: Because of my husband's job-location change, we had to sell our house in Michigan where the home-sale market is slow. His employer offered no relocation benefits, but at least my husband has a job.After listing our home on the market for six months with no purchase offers, we were unable to keep up the mortgage payments, and we defaulted. The realty agent suggested a "short sale'' for less than the mortgage balance.Rather than foreclose, the mortgage lender agreed to accept a purchase offer for about $16,000 less than the mortgage balance. We were happy to get rid of the house and its mortgage. But then we received an IRS 1099 form showing $16,000 taxable income to us. Is this a mistake?
Answer: Unfortunately for you, it's no mistake. When a mortgage lender agrees to a "short sale'' for less than the mortgage balance, the IRS considers the amount received by the lender, which was less than the amount owed, to be taxable "debt relief'' income to you as the borrower.The IRS reasons that because you won't have to repay that $16,000 loss the lender incurred, it is the same as if you received $16,000 income, such as job salary. Though we might not agree with the IRS's viewpoint, debt relief in the form of a mortgage short sale is taxable to borrowers.