If you are one of the millions affected by the housing crisis, and last year managed to get your home sold to another buyer in a pre-foreclosure or short sale, then I have some good news and some bad news. If the amount that the sale was short of the mortgage debt was forgiven by your lender, as commonly happens, and you walked away from the house owing nothing, then the bad news is that the canceled debt which was forgiven is viewed as ordinary income by the IRS. It does not matter that you never saw any money, the IRS still view it as a cash benefit, or income, to your finances.
Now the good news. Because this has happened to so many people, and the IRS feels your pain, they have changed the rules. The income is not taxed if house was your principal residence, and not just an investment property. This exclusion applies to property sold from 2006 up to 2013, and is subject to a maximum of $2 million for a couple or $1 million if you file separately. You can read all about the details of this in IRS Publication 523, which you can find at https://www.irs.gov/pub/irs-pdf/p523.pdf.