A short sale is when you sell your house with a mortgage for less than what is owed on the mortgage. If your house is underwater, you owe more on the house that what you could sell it for, including closing costs. (Of course, your house could also be flooded out, but I am not talking about that here.)
As a real estate attorney in South Carolina I am well familiar with the The Mortgage Debt Relief Act of 2007 that is further explained on irs.gov. Normally, if a creditor forgives a debt that you owe in whole or part (outside of bankruptcy), you have taxable income for the amount of the debt forgiven. That is a problem for someone who cannot pay a debt to then pay the taxes on a forgiven debt. Congress started seeing the housing crisis coming in 2007 when they passed the Mortgage Debt Relief Act of 2007.
This forgives a taxpayer of debt relief income when he or she sells their primary residence (the house you have lived in) through 2012. This law may be renewed again; it may not.
Tom and Betty hired me to defend their foreclosure case against their high end home on the beach. They had many valid defenses which I fully explored; I filed my Answer and Counterclaim for them. While I was holding up and investigating the case in the court for over eighteen months, their agents were negotiating with another arm of the bank to do a short-sale. All Tom and Betty wanted was a waiver of the deficiency judgment that the bank was seeking against them which probably would have been well into the mid-six figures. Finally, the bank agreed to the short sale that we asked the bank for that the cash buyer was willing to pay. My clients were concerned that they would be exposed to debt relief income, which in their case would have been over $150,000. However, I am well familiar with the The Mortgage Debt Relief Act of 2007 and could give them quick reassurance that they would not face this problem so long as the closing would be completed by December 31, 2012. (The closing is set for September).
Tom and Betty got out of a very bad situation in a very good way. They were able to get their house sold thanks to their real estate agent and I, as their attorney, was able to validly hold the case up in court to give the negotiators the time they needed to work their magic. However, time is of the essence here as it always is in real estate and law. If you are going to short-sale your primary residence, you must finish the closing by December 31, 2012. Otherwise, you will have to pay taxes on the debt that your lender relieved you of. Get a good lawyer and a good real estate agent if you are in foreclosure that are versed in these issues.