Legal Question in Real Estate Law in California

Technically, the amount of the debt forgiven is considered income to you. The lender may have reported it to the IRS, but would send you notice if they did. You should first check if they have by going through your mail from them and the see if reporting it will not effect your overall tax liability [I believe you can report the sale as causing a capital gain loss, but you should check with a tax expert, or look through a current tax advisory book such as Lassiter or Block's]

You actually have two tax issues here - capital gains/loss and recognized income from forgiven debt. Your lender, unless it is a private money lender who has no idea what they are doing, will send you a 1099-C for the amount of the debt they wrote off in the short sale, which the IRS will treat as a business expense to the lender and regular income to you. You will have to report that on your taxes. There is, however, an amnesty in place on taxation of that income. So while you have to report it, you shouldn't have to pay taxes on it. If you sold the house for less than you paid for it, that is a capital loss. However, I am fairly certain that you can only use that loss to off-set capital gains, and there may be further restrictions on it. In addition, I am 99% sure you cannot use it at all except to the extent it exceeds the amount of the forgiven debt. I strongly recommend that you use a professional tax preparer this year.

Yes, you need to report it. Use Schedule D and Form 8949. Your lender is liklely to send you (and the IRS) one or more 1099s, so there's no secret to be kept, and you are entitled to at least a small deduction for your capital loss, maybe more, and a loss carryforward. This could be a good year to have your taes done professionally, if that hasn't been your past practice. I believe the so-called "forgiveness" on an uncollectible mortgage is not currently being taxed as ordinary income (or at all), so full reporting and disclosure is to your advantage, albeit slight in most cases.