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If you simply walk away, the default balance will be reported as taxable income. If you short sell, the defaulted balance will not be treated by the IRS as taxable income.

In either case, the unpaid balance should be reported as potentially taxable. And if the short sale or foreclosure happen in 2013, the unpaid balance will not be taxable income as it is from the OP's principal residence.

If a short sale or foreclosure happens in 2014 or later, the principal residence provisions for unpaid debt go away. In that case, the OP would have to look to some other way to exclude the debt forgiveness - likely the insolvency exclusion, given the large amount he's underwater.

To the OP's issue - there is also the potential for a deed in lieu of foreclosure. But I understand those are pretty tough to come by.

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