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.