Short sale and deficiency judgments

There seems to be alot of misunderstanding about deficiency judgments and 1099's-- and understandably so, the average person doesn't deal with this everyday. What I'm about to post is procedural information and not legal advice, you should consult an attorney for legal advice.

What's a 1099 (we'll get more meaty then this I promise)? A 1099 is an IRS form that reports payment to a taxpayer and the IRS. Much like an employee and the IRS receive a W2 at the end of the year to show how much income that employee received, a 1099 achieves the same thing.

When a debt is forgiven, the IRS says that the amount that is forgiven becomes taxabe. They call is COD or Cancellation of Debt income. Their reasoning is that as long as you owe the money to someone, it's not your money and you shouldn't pay taxes on it, however, the moment that you no longer owe it (the debt is cancelled) it is now income and subject to taxation. Easy enough.

In a short sale (or foreclosure) when their is a portion of debt forgiven, the lender may send the borrower a 1099 showing that amount as income to them. There are ways to get out of this tax burden, one of which is the Mortgage Forgiveness Debt Relief Act of 2007 which most people are aware of. Even if you are an investor and may not qualify for this exemption, you may still be able to prevent a tax liability on a short sale.

A deficiency judgment is very simply a court judgment acknowledging that the borrower did not perform on all or a portion their obligation to pay and that the lender has a right to collect. When you buy a house you sign two documents:
1) A mortgage or deed of trust (same thing essentially-it depends on the state as to which instrument is used)
2) A Promissory note (personal promise to repay)

The signed mortgage gives the lender a right to the house as collateral (so they can foreclose). The signed promissory note gives the lender a personal guarantee and allows the lender to pursue the borrower(s) personally.

There are a few reasons that seem to make a deficiency more unlikely after a short sale then after foreclosure.
One is that this can be a point of negotiation during a short sale. It is possible to get the lender to waive this right while negotiating the short sale, whereas there typically is not much negotiation happening on a foreclosure.
Another reason is that it will require a lender to initiate a lawsuit to get a deficiency judgment (the word judgment implies that it was granted by a judge through a legal proceeding) after a short sale, whereas in some states the lender already has to start a lawsuit to foreclose. This means that getting the deficiency judgment is already half way done with a foreclosure (in these states) and only requires a quick hearing in front of the judge--mouch more likely that they'll opt for the judgment.
A third reason is that through the short sale, the lender can usually easily determine that the borrower is not "collectible" meaning, they are not worth pursuing because the probability of the lender collecting anything is slim.

There are creative ways (beside bankruptcy) to minimize the deficiency judgment if it looks like the lender won't waive that right. Also, it's important to remember that the lender can't do both (issue a 1099 AND pursue a dificiency judgment). It's one or the other.