In 2004 my husband and I purchased a house in VA and lived there for 3 years before my husband retired from the navy and received a job in MD. The house we purchased was a HUD home and in the 3 years we lived there we really didn't do many improvements other than cosmetics.

In 2007 my husband retired and we move to MD. We were able to secure a second mortgage to purchase a house in MD. Also, because our HUD home was worth more than what we paid for it, we were able to take out a home equity line of credit to use as a down payment for our second home in MD allowing us to secure a lower interest rate. It was our intention to then sell the first home in VA and pay off that mortgage and the line of credit, however, it was right at this time that the housing market began a serious decline. We were stuck with the house and could not sell it.

Now that home sells are beginning to increase we are once again hopeful that we can sell it for what we owe (the mortgage + the line of credit).

It was my understanding that if the house sold within the first 3 years after moving out we would not have had to pay a capital gain tax. Obviously, we are now concerned that we will be required to pay this tax. Will that be the case for us and others who choose to honor their mortgage obligations rather than short selling?

Yes, you are liable for capital gains taxes on the PROFIT from the sale of your house under the circumstances described.

You can deduct the costs incurred when you bought the house and when you sell the house, to include the realtor'a commission.

Did you rent the house for any of the last six years?

Short selling if I understand right usually triggers a tax obligation if the difference is forgiven.. so its not like they get off easy unless I seriously misunderstood how that works.