"This is accomplished when you meet the IRS use and ownership tests: You own and live in the home for two out of the five years before the sale.And your actual habitation of the home doesn't have to be sequential, notes Mark Luscombe, lawyer, accountant and principal tax analyst at CCH Inc., a Riverwoods, Ill.-based provider of tax law information and software. The IRS lets you aggregate your time living in the house to meet the two-year residency requirement."Generally, if you owned and used the home as your main home for periods totaling at least two years within five years ending on the date of these sale, you're eligible for the exclusion," says RIA's Trinz. "You look back at the last five years. Ownership and use may be at two different times. This would apply if you owned a home for five years, but didn't use it as your primary residence for that full period. For the first three years, you rented it and then moved into it as your main home for the final two before you sold it."
Hope this helps or just go on to http://www.IRS.gov and type principal residence. You will find out. Good Luck.
CERTIFIED DISTRESSED PROPERTY EXPERT
As everyone has commented, your CPA knows best.
For your information only, I will quote my notes from my brokers continuing education, Feb., 2010:
"The IRS now used the term MAIN HOME in some of their publications. Principal and main mean the same home. Another term you see in the IRS code is personal residence. You can have more than one personal residence, but only one main home. A Main Home is the home in which you live most of the time, and it could change from year to year.
Another example tat puzzles some people is that your Main Home could be a property that you rent from someone else even though you own a personal home. You have a home in Lake Tahoe that you use on weekends, vacations and holidays and never rent out. You rent an apartment in San Francisco whre you work. The apartment is your Main Home.
The IRS will look at your place of work and another important considerations is where your children attend school, where you vote and get your magazines, or attend church. Your utilities bills can place where you live during the year fairly accurately.
The new law also allows a Main Home for each spouse."
I bit long of an answer, but just in case you wanted to know and it was useful ....
Certified Short Sale Professional
Certified Home Retention Specialist
Blogging at: http://TheBremnerGroup.com/blog
This is really a tax question that should directed to a CPA; however, I think I can provide some limited peace of mind. You will be pleased to know that debt relief act of 2007 Emily mentions was increased by three years (from 2010 to 2013) pursuant to H.R 1424, the Emergency Economic Stabalization Act of 2008.
The debt relief act of 2007 only applies to Federal tax relief; however (from http://www.ftb.ca.gov/aboutFTB/newsroom/Mortgage_Debt_Relief ):
"For discharges occurring on or after January 1, 2009, California does not conform to the federal provision. Generally speaking, under the current law, the amount of debt discharged is taxable to California. However, several bills pending in the Legislature would extend and modify California mortgage forgiveness debt relief to conform more to the Federal law: AB 1779, SBX8 32, and SBX8 25. Watch this page or subscribe to â€œLegislation Informationâ€ for updates on pending legislation."
I can email you a 6-page document regarding Taxation of Foreclosures and Short Sales for more important information if you like, just take your mouse and hover over my picture and then hit the "Contact Me" button.
It's called Form 982 and you can talk to your accountant about it or simply google "Mortgage Debt Forgiveness Act. 2007"
If it is not your primary residence you MAY be taxed on the difference and you'll be taxed at whatever your tax rate is depending on your income bracket. Not all banks are issuing 1099C's though.
I have closed Wells Fargo short sales, you actually don't have to be late or miss payments to do a short sale with Wells Fargo, it's not a requirement. The process with Wells Fargo takes approx. 35-45 days to get an approval.
Let me know if you'd like any other help with your short sale. Please email me directly as I don't check back with Trulia for the same posting.