Certain farm debts: This exemptions only applies to debt incurred directly from an operation of a farm. If more than half your income from the past three years came from farming, and the loan was owed to a person or agency regularly engaged in lending, your cancelled debt is generally not considered taxable income.

Analysis

Since 2007 and 2008, California conformed, with modifications to IRC section 108 (a)(1) (E) that allows a limited amount of COD income resulting from the foreclosure or short sale of a qualified principal residence to be excluded. This exclusion does not currently apply for any foreclosure or short sale that occurs on or after January 1, 2009. Danny made his short sale in 2012. "The Mortgage Forgiveness Debt Relief Act of 2007 was enacted on December 20, 2007 (see News Release IR-2008-17). Generally, the Act allows exclusion of income realized as a result of modification of the terms of the mortgage, or foreclosure on your principal residence. " (The Mortgage Forgiveness Debt Relief Act and Debt Cancellation 2012) This act passed would have helped Danny if the sale was made prior to 2009. Current findings point to the need for Danny to pay taxes on the short sale and any cancellation of debt assumed by the process.

There is a new law in California Senate Bill 458, signed into law on July 15, 2010 and effective immediately as an urgency statue, corrects major defects in Code of Civil Procedure Section 580(e). This law states that when any lender agrees to a short sale, it cannot go after the borrower for any shortfall or deficiency between the sale proceeds and the loan amount. Although this has nothing to do with the taxes incurred through the short sale or COD, it does however keep Danny from being hasseled over the left over deficiency.

This new law offers a sort of protection for the homeowner....

The prior law gave limitations to lenders with the new law applying an extension. This new law extends this prohibition to all junior lenders as well. Thanks to this new law, homeowners are not afraid to use short sales to cancel debt because now there is limited post-sale liability that they might incure to junior lien holders.
Danny acquired a recourse note to pay for the home he had to short sale. A recourse note is a debt instrument a lender can use to take action against the borrower or endorser personally, in addition to foreclosure of the property covering the lender's mortgage. The short sale of the property and the laws enacted that kept Danny from being too liable enabled him to have less due on the property to the declining values of said property. Although he has to pay taxes for the cancelled debt, there are few negative consequences to his actions and to his credit.

The new law which was enacted to provide options to homeowners in need of a short sale. Danny because he is not insolvent or bankrupt is most likely to incur more taxes on his income tax. Those are really the only penalties from this sort of action.