Recourse vs. Nonrecourse
When a debt is canceled by any means (deed in lieu of, foreclosure, short sale, cancellation of debt), the tax impact depends on the type of debt.
Debt for which the borrower is personally liable is recourse debt, all other debt is nonrecourse debt.
RECOURSE debt holds the borrower personally liable for any unsatisfied amount owed when the property is surrended (by any means).
If a lender forecloses on property subject to recourse debt, and cancels the portion in excess of the fair market value (FMV), the canceled part is ordinary income from cancellation of indebtedness. That figure must be included in gross income unless it qualifies for an exception of exclusion (personal residence, Mortgage Debt Relief Act, bankruptcy or insolvency).
Additionally taxpayer may realize a gain or loss on the disposition of the property by the difference between the tax basis and the FMV at the time of foreclosure.
NONRECOURSE debt is satisfied by the surrender of the property regardless of FMV. Borrower is not personally liable for the debt.
If nonrecourse debt is abandoned, foreclosed, short sale or repossessed, it is treated as a sale. The usual method to determine gain or loss is used. The balance of the nonrecourse debt at the time of the disposition is treated as the amount realized (in other words you actually sold it for the total debt of the property, not just what a short sale closing document may indicate).