Here's the scenario: Homeowner stopped making payments on both first mortgage and HELOC. 18 months later a short sale is approved by both lenders. Lender #1 gets the bulk of the sale and nets $200k from a $350k note balance. Lender #2, the junior HELOC lender accepts $10k as full satisfaction on a $125k balance.

Lender #1 was required per the terms of the note to apply the $200k toward the $30k of unpaid interest first. Then principal gets credited; then the charge off.

Lender #2 was also required per the terms of the note to apply the $10k toward the $12k in unpaid interest then charging off the $2k in unpaid interest along with the principal.

Both lenders send the homeowner IRS 1098-Interest Paid of $30k and $10k that the homeowner utilizes in filing their taxes; providing a $40k mortgage interest tax deduction.

Both lenders issue an IRS 1099-C for the debt cancellation. However, regardless of the The Mortgage Debt Relief Act of 2007 which expires this year the homeowner qualified for debt forgiveness exemption under the IRS insolvency exclusion which does not expire. The insolvency exclusion requires the individual to owe more than they are worth; hence they're deemed insolvent and thus exempt from any tax relating to the debt forgiveness. In this scenario, the homeowner owed well in excess of $475k on the home and other debts yet the property was only worth $240k. Absent any other substantial assets whose combined value would exceed $475k he was deemed insolvent.

Follow up with your customers to make certain they received their 1098s from the short sale lenders. If not, have them contact an attorney in these regards in order to determine if the note required the same application of payments. Also, don't worry if Congress doesn't extend The Mortgage Debt Relief Act of 2007 providing your customer doesn't have a lot of assets.

For the record, I'm neither an attorney nor CPA. This is not intended as legal, accounting or tax advise. I am only reporting what I have observed occur in numerous short sales by the homeowner's attorneys and accountants.

According to FICO, a consumer with a starting FICO credit score of 720 will see his or her score drop by 130 to 150 points after a foreclosure. By comparison, that consumer's score will drop 95 to 115 points after a short sale. FICO spells out this and further mortgage delinquency scenarios in a blog post.

Minimum waiting periods before borrowers are eligible for a Fannie Mae loan after a foreclosure or short sale also favor short sales somewhat. Homeowners who went through a foreclosure and did not strategically default have to wait three years, compared with two years, under certain circumstances, for those who went through a short sale.

Results are shown here. The first chart shows the impact on the score for each stage of delinquency, and the second shows how long it takes the score to fully “recover” after the fact.

•The magnitude of FICO® Score impact is highly dependent on the starting score.

•There's no significant difference in score impact between short sale/deed-in-lieu/settlement and foreclosure.

•While a score may begin to improve sooner, it could take up to 7-10 years to fully recover, assuming all other obligations are paid as agreed.

•In general, the higher starting score, the longer it takes for the score to fully recover.

•Even if there’s minimal difference in score impact between moderate and severe delinquencies, there may be significant difference in time required for the score to fully recover.

This study provides good benchmarks of score impact from mortgage delinquencies. However, it is important to note that research was done only on select consumer credit profiles. Given the wide range of credit profiles that exist, results may vary beyond what's in the charts.

The exclusion for up to $2 million of cancellation of qualified debt secured by a principal residence was originally enacted in the “Mortgage Forgiveness Debt Relief Actof 2007 and extended by the Federal Bailout Legislation passed on October 3,2008. Unless Congress takes action, the exclusion is scheduled to expire after 2012.

Homeowners who have been waiting for their mortgage holders to start the foreclosure process for their delinquent mortgages might want to seek a short sale of their residence soon. Given how members of Congress cooperate, don’t count on them extending the Mortgage Forgiveness Act.

It is important not to wait too long. At the end of the year there will be many homeowners with Short Sales in play, all trying to meet the deadline. Most lenders are understaffed for current volumes, so imagine what year end will be like.

The consequences of not making the deadline could be catastrophic, so don’t delay the process if you can’t see any other way to avoid the foreclosure proceeding. Remember, most short sales take 4-6 months, with some taking much longer.

You should contact your accountant to determine what the downside is to not acting and losing control of the process. Remember to find out what happens if you do a deed-in-lieu, or allow the foreclosure to proceed. You must understand the tax implications of each action or inaction.

I would also find out what happens if you do get a large 1099 for mortgage forgiveness debt. Can you discharge it with a bankruptcy?

Remember any plan is better than no plan at all.

Here is an incredible concept: Life is 20% what happens to you and your family, and 80% how you deal with it.

In tough economic times, many families are being forced into the short sale, foreclosure, deed in lieu and the bankruptcy route. Families can rent a home, recover their credit and buy again. All it takes is commitment to getting your family back to solid financial health. You need to have a plan and have everyone in the family on board.

This means eliminating expenses that are not necessary and having a plan to save for whatever goals your family thinks are important.

Going through this exercise is critical to success. The following chart while not perfect, gives you an idea of how long you will need to wait before you can purchase a home again after a financial setback:

You should be able to buy a new home after you have cleaned up your current credit problems.