Will we pay less tax on short sale or foreclosure of our Calif investment property? (income tax, negotiating)

[dooginvestor]

(Also posted in San Francisco forum)

My basic question is this:
Should my wife and I go with a short sale or foreclosure of our Calif investment property? I believe my debt will be forgiven either way, so the real question is: Which will I pay less tax on?

We purchased a house in California for investment for $600K three years ago, and then refinanced it (does that make it a recourse loan?). We put 25% down ($150K). My wife lost her income so we cannot afford the payments. We have it up for short sale -- a buyer is willing to pay $300,000. Will we pay less tax if we go with the short sale or if we go with non-judicial foreclosure? (The lender has not filed a judicial foreclosure.) The house is due to foreclose at the end of this week.

Our loan is currently $485K. If the property sells for $300K, the amount we owe would be $185K. If this amount is forgiven, we would need to pay ordinary income tax on it, which at 30% would be $55.5K. We want to avoid paying that tax (or find a deduction to offset it -- is there a deduction in this picture?).

ARGUMENT FOR FORECLOSURE
Our real estate attorney says that if a foreclosure sale (trustee sale) is non-judicial, the forgiven debt will always be nonrecourse debt (borrower is not personally liable for debt). Page 3 of IRS pub. 4681 says that "If you are not personally liable for the debt, you do not have ordinary income from the cancellation of debt."

Therefore, it would seem to follow that if we go to foreclosure, we won't owe that $55.5K tax on the forgiven debt. (I am fully aware my credit will be hit much harder with foreclosure than short sale.)

Can anyone point me to the law that says that for non-judicial foreclosure sales of investment properties, forgiven debt is nonrecourse debt?

ARGUMENT FOR SHORT SALE
Of course, our credit won't be hit nearly as hard with a short sale. We are negotiating with the lender, who is asking us to pay $6000, and they will forgive our debt. In our situation, is there any way to prevent having to pay tax on the forgiven debt? We read that it would be considered a recourse loan, being that it's refinanced. Our attorney has told us to ask them to specify it as a nonrecourse debt, which we will do tomorrow. Does the same quote given above from IRS pub. 4681 apply equally to short sales and foreclosures of investment properties?

It looks like we will get a cancellation of debt in either case, so which route we go would seem to depend on whether we can also get zero ordinary income from the cancellation of debt.

[wileynj]

I believe short sale is the better option. With a foreclosure..the lender may be able to go after you still for the difference... a short sale is a negotiation... a settlement! With foreclosure, you may have to file for bankruptsy as well in order to be protected yourself from claims/suits against you by the lender. This is really a question for an attorney.

[shellytc]

Doog, I think you have some good advice from your attorney, now it is time to get some from your accountant....they are the only ones that can give you good tax advice. And we don't know what congress may do about "forgiving" any taxes owed on short sales...

shelly