Cancellation of debt as taxable income for short sale on prior residence turned into rental?

See

It looks like the mortgage forgiveness act only applies to your primary home. If you've moved back into the smaller home after selling the larger one, then it is now your primary residence. The law probably addresses rental homes turned into primary residence homes (ie. maybe the mortgage forgiveness does not apply), but I don't know the details.

If the debt is non-recourse it is not included in 1099-C. If you're in bankruptcy, the debt is not included. If you're in insolvency then part of the debt is not included. See section 2 in the link I sent you.

1. Is Cancellation of Debt income always taxable?

Not always. There are some exceptions. The most common situations when cancellation of debt income is not taxable involve:

• Bankruptcy: Debts discharged through bankruptcy are not considered taxable income. * Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you.You are insolvent when your total debts are more than the fair market value of your total assets.Insolvency can be fairly complex to determine and the assistance of a tax professional is recommended if you believe you qualify for this exception. * Certain farm debts:If you incurred the debt directly in operation of a farm, more than half your income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, your cancelled debt is generally not considered taxable income.The rules applicable to farmers are complex and the assistance of a tax professional is recommended if you believe you qualify for this exception. * Non-recourse loans:A non-recourse loan is a loan for which the lender?s only remedy in case of default is to repossess the property being financed or used as collateral.That is, the lender cannot pursue you personally in case of default.Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income.However, it may result in other tax consequences, as discussed in Question 3 below.

There is no cancellation of debt income unless the debt is a recourse loan. If it is a recourse loan, there is no exclusion available for the cancellation of qualified residential mortgage debt because it is not the disposition of her main home. It is the disposition of residential rental property. She may elect to exclude this type of debt under the rules for cancellation of ?qualified real property business indebtedness?. See IRC Section 108(a)(1)(D) and 108(c). The maximum amount to be excluded is limited to the adjusted basis of depreciable real property before the discharge. The definition of qualified debt is the same as it is for principal residence debt (amount borrowed to build, acquire or make capital improvements). Note that if the rental was used by the taxpayer for more than 14 days in the year, it is disqualified from this provision. See CCA 200919035, February 20, 2009. The disposition of business property is accounted for on Form 4797.

Also see pages 7 & 10 in IRS Pub 4681: Qualified Real Property Business Indebtedness for more information. I also recommend you seek professional help for this disposition, as accounting for the disposition of rental property and debt cancellation can get quite complicated.