From William Perez,
Your Guide to Tax Planning: U.S..
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Lenders sometimes cancel or forgive a person's debt. While this relieves the debtor of an immediate financial stress, it often triggers a tax liability. Under the tax law, canceled debt is considered income to the debtor and is included as part of the debtor's income. Not only does this impact how much tax is paid, but can reduce deductions that are limited based on adjusted gross income.

Current tax law provides three remedies for excluding canceled debts from taxes. There's an exclusion in the case of insolvency, for cases involving bankruptcy, and a new exclusion for certain types of mortgage debt. The mortgage exclusion is the most important of these exclusions.

In December 2007, Congress passed the Mortgage Forgiveness Debt Relief Act. This new law provides some relief for homeowners who lose their house through foreclosure or short sales, or who restructure their mortgages with a lower principal amount. The law enables individuals to exclude from tax up to $2 million of certain mortgage debt canceled by lenders. There are a number of criteria that need to be met to qualify for this exclusion.

Canceled mortgage debt that does not meet these criteria might still be excluded using the rules for insolvency or bankruptcy. People with home equity loans and cash-out or debt-consolidation refinances will need to do some extra bookkeeping to make sure they can take full advantage of all the tax exclusions that apply to them.