Legal Question in Real Estate Law in California

The key thing you need to know is that a short sale does NOT NECESSARILY automatically extinquish the entire debt. California has an anti-deficiency statute that limits a "purchase money" lender on residential property to whatever they can get for the property if the borrower defaults. It also applies if the lender forecloses through a trustee's sale, which is far and away the most common form of foreclosure. If you have ever refinanced the property, however, or have any debt on the property that was not placed at the time you purchased it and used entirely for the purchase, it is not a purchase money loan. In that case a trustee's sale would bar any further action to collect the debt, but a short sale would not, unless the lender agrees in the short sale agreement to release and write off the balance.

The other thing you need to know is that if they do not collect the balance from you, whether because they are barred or because they agree not to as part of a short sale agreement, they will write off the balance as a loss on their taxes. In order to do that, they have to move the money on their books from their assets to their expenses. When a business deducts an expense the tax man wants to know who it went to and why, because often there is either sales tax or income tax or both to be paid by the person who gets the money. So the bank must issue you a 1099-misc, which tells the IRS, FTB and you that the bank is declaring the written-off balance as a payment to you. The IRS and the FTB will then treat that as income to you and expect you to pay taxes on it. That can wind up being a really nasty shock.