Alert: This article is no longer current due to recent tax law changes (H.R. 3648).

Unless you pay absolutely no attention to the news, then no doubt you’ve heard about the skyrocketing rate of home foreclosures nationwide resulting from the sub-prime loan debacle. The East Bay has been hit particularly hard, especially Contra Costa County, primarily because it’s the place so many first-time homebuyers get their feet wet in the Bay Area housing market.

Of course, many homeowners facing foreclosure are looking for a way to ease the pain of this situation, as well as avoid the black mark it will leave on their credit rating. Many can’t or simply don’t want to go through the hassle of refinancing, or trying to get the lender to modify the terms of their loan. So, another “solution” has been growing in popularity in the Bay Area: the short sale.

A short sale, essentially, is what happens when a homeowner — with the mortgage lender’s approval — sells his or her property for less than what is owed on the mortgage. While lenders will allow some homeowners in a jam to take this route, they agree to it begrudgingly because they stand to lose a big chunk of the loan’s value. And they don’t make it easy for homeowners, who are required to prove their hardship. This process can take weeks, and is pretty much the equivalent of an audit.

There’s something else homeowners should keep in mind. A lender can report a short sale transaction to a credit bureau. So, while it may be better than a foreclosure, a short sale can definitely leave a significant smudge on your credit report. And as if having to sell your home because you are facing foreclosure isn’t bad enough, there’s one more little “kick in the pants” that homeowners may have to deal with following a short sale, courtesy of the Internal Revenue Service.

This is the problem: The homeowner who sells his or her home in a short sale may face a sizeable tax bill based on the amount of the mortgage balance – even if the lender technically “forgave” the debt by agreeing to the short sale. The property will be taxed as if it were sold for the total outstanding amount of the loan, or the sale price, if it’s higher. Taxability of the gain and deductibility of the loss depend on the nature of the property.

For example, a homeowner owes $500,000 on a house that was purchased for $530,000. It is now worth $480,000. If the property is foreclosed on, and the homeowner gives the property to the lender — or if the lender accepts a short sale arrangement — then the homeowner is taxed as if the property had been sold for $500,000. Depending on the situation, the former homeowner may be on the hook for thousands of dollars of tax.

However, not everyone will end up paying tax on a short sale, or at least, not too much. There is some relief for homeowners who are insolvent. This means the sum of your debts, including the mortgage, is greater than the value of your assets.

My advice for those who could take a big tax hit from a short sale? If you are facing foreclosure, move out and put the home up for rent. This way, the loss may be tax deductible because the home is now a rental property.