It looks like short sales and principal reductions will continue to work as intended, at least for one more year. The fiscal cliff bill that Congress just passed extends the Mortgage Debt Forgiveness Relief Act through the end of 2013. This means that homeowners who have a portion of their mortgage debt forgiven in a short sale or a loan modification will not be taxed on the forgiven amount. Without this tax exemption, the IRS would have started taxing forgiven mortgage debt as income on January 1, 2013.
This extension will continue to encourage short sales on underwater homes and will keep the terms of the National Mortgage Settlement (which includes principal reduction provisions) from doing more harm than good.