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I've read IRS Publication 4681 10 or 15 times about this and I do believe if their accountant can show that they were insolvent at the time of the sale, they don't have to show it as income.
I had an appointment with my accountant about one of my a rental I own personally that I have decided to short sale. The IRS insolvency rule would apply if you can show you are insolvent the day before the lender forgives the debt. If you are not insolvent then as an investment property, you can write off the loss, which in turn offsets some of the forgiven income. Therefore, the tax ramification should not be as bad as one might believe.
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