Four years after the residential real estate bubble began to burst, most markets are still depressed.

If you borrowed heavily to buy at the top of the market or overindulged on home equity loans while prices were increasing, you may have mortgage debt in excess of your home's current value.

If you are then forced to sell your property in what is known as a short sale, you could face an income tax hit too--or maybe not. This article covers the basic tax implications of personal residence short sales.

Short Sale with Recourse Mortgage Debt

A sale when the mortgage debt exceeds the net sale price (after subtracting commissions and other selling costs) is called a short sale. The easiest way to explain the tax implications is with some examples.

Example 1: Principal Residence Short Sale for Tax Gain: Say you paid $190,000 for a home you could currently sell for $250,000. However, the first and second recourse mortgages total $280,000. If you sell, you'll have a tax gain of $60,000 because the sale price exceeds the property's tax basis ($250,000 sale price $190,000 basis = $60,000 gain). Will the IRS cut you any slack since you're $30,000 in the red ($280,000 debt versus $250,000 sale price). Nope. The sad truth is you can have a tax gain without any cash to show for it. That's because the amount of recourse mortgage debt doesn't affect the tax gain/loss calculation. The good news: the $60,000 gain is probably federal-income-tax-free, thanks to the principal residence gain exclusion break. An unmarried person can exclude up to $250,000 of gain, and married joint filers can exclude up to $500,000. To qualify, you generally must have owned and used the home as your principal residence for at least two years during the five-year period ending on the sale date. Assuming you qualify for the exclusion, the $60,000 gain won't trigger any federal income tax hit. Depending on your state of residence, there may or may not be a state income tax bill.

Example 2: Vacation Home Short Sale for Tax Gain: Same basic situation as Example 1, except this time assume the property is a vacation home instead of your principal residence. Now you have a $60,000 tax gain that you can't exclude even though you get no cash out of the deal. Tough break.

Example 3: Short Sale for Tax Loss: Say you paid $310,000 for your principal residence that you could now sell for only $250,000. The first and second recourse mortgages total $280,000. You'll have a $60,000 tax loss if you execute a short sale ($250,000 sale price $310,000 basis = $60,000 loss). Does the IRS let you to deduct the loss? Nope. You can only claim a tax loss on business or investment property. In most states, the same principle applies for state income tax purposes.

What about the Excess Debt?

The next question is what happens to the $30,000 of excess mortgage debt (the amount in excess of the net sale price) in the preceding examples? Usually, lenders will not grant any relief to short sellers. If that's your fate, you'll have to find a way to pay off the excess $30,000, and you won't get any help from the IRS for doing so. However, if the lender decides to forgive some or all of the excess $30,000, the forgiven amount constitutes cancellation of debt (COD) income for federal income tax purposes (see the sidebar).

Short Sale with Nonrecourse Mortgage Debt

In some states, some personal residence mortgages can be nonrecourse. With a short sale of a property burdened by one or more nonrecourse mortgages, the lender cannot go after you for any deficiency (negative difference between the sale price and the loan balance). Even so, the lender might agree to a short sale in order to collect what can be collected now before the property's value declines any further.

When property subject to a nonrecourse loan is sold in a short sale, the transaction is treated for federal income tax purposes as a sale for a price equal to the nonrecourse loan balance. The actual sale price is irrelevant. This conclusion is based on a 1983 Supreme Court decision in Commissioner v. Tufts.

There cannot be any COD income because the nonrecourse mortgage obligation is deemed to be fully satisfied in the short sale. Therefore, the short sale can only result in straightforward tax gain or loss without any COD issues.

A tax gain is triggered if the nonrecourse loan balance exceeds the property's basis. However with a principal residence short sale, the entire gain may be federal-income-tax-free thanks to the aforementioned gain exclusion break.

If the basis of a personal residence exceeds the nonrecourse loan balance, a short sale will trigger a nondeductible tax loss.

For More: SmartMoney Real Estate Calculators