Short Sale Tax Implications

[Victoria36]

I live in Washington State and have my house on the market. I have a buyer and the only way to sell is to do a short sale. My home is in a deed of trust foreclosure not a morgage foreclosure so there is no deficiency judgement allowed.
My worry is that I have read that the IRS can come after me as counting the difference between the tax basis (the amount home purchased for plus improvements if any minus depreciation) and the amount home sells for as MY taxable income.
I bought the home at $220,000 a year ago and have an offer for $200,000. My first is for $187,000 and my second is for $33,000. I am 6 months in arrears on both loans plus the first has a pre-pay penalty I have a first and a second mortgage with the same lender. No equity in it. Prices have dropped alot in the last 6 months and homes are sitting on the market for much longer in my area. There are 3 other homes for sale on my block.
The lender won't even talk to me about what they'll accept as a short sale until I have a signed around offer.

Does anyone have any advice or first hand experience of completing a short sale and then getting penalized on their taxes?

Any advice at all would be very helpful.
Thank you.

[Godzillarama]

It's the 1099

I'd have an attorney make certain the lender doesn't file a 1099 showing the difference. If they agree to not file a 1099, you should be okay.

[HHM]

Note, your right about the fact taht 1st mortgage foreclosures are typically not allowed deficiency balances, but that is not always true with 2nd mortgages, in fact, it's quite common that 2nd mortgages are allowed deficiency balances, so you may want to make absolutely certian the 2nd mortgage cannot get a deficiency.

[miss puff]

I am curious Victoria how this all turned out. We are two months behind on mortgage (we planned to let it go). Put the house on the market on Friday, Dec 29th. Had a showing Saturday, December 30th and have an offer today, January 3rd. Our realtor knows we are looking at a short sale so we can unload the house before it goes to foreclosure. Called the bank and they want a hardship letter along with the offer. Is a hardship letter a boohoo, woe is me, letter? Really nothing major happened, we were just stupid. Do they have dummie letters? lol! I have to laugh because we expected the house to sit for months because houses are NOT moving around here right now. They sit and sit for months and months. So, I am kind of freaking out. I hope the bank accepts the offer. Does anyone know what the norm is for what the bank will take for a loss? THanks :-)