With all the talk of foreclosures, short sales, workouts, principal reductions, etc., I am surprised we have not heard more about the Mortgage Forgiveness Debt Relief Act of 2007 (the Act). Under the Act, people may be able to exclude debt forgiven on their principal residence. The balance on the loan must be less than $2 million ($1 million for a married taxpayer filing a separate return, and the debt must have been forgiven in 2007, 2008, or 2009.
It appears to apply whether the debt was forgiven pursuant to a short sale, a foreclosure, or a workout with the lender to reduce the principal balance. Since just yesterday Ben Bernanke suggested that lenders should forgive portions of mortgages when the borrowers are at risk of defaulting, the Act will be very important for many people.
To qualify under the Act, the debt must have been used to buy, build, or substantially improve principal residences, as well as being secured by that residence. That would seem to mean that folks who pulled out tons of equity to pay off credit cards, buy boats, etc. might not qualify.
More details are on Form 982, and its accompanying instructions. Apparently, because this revision took place so late in the year, many tax preparation software packages do not include the updated form.