There are two types of mortgage debt in the tax code. There's acquisition debt and home equity debt. The distinction between the two impacts which exclusion may apply. Acquisition debt is debt whose proceeds were used to buy, build, or substantially improve a principal residence. Home equity debt is debt whose proceeds were not used to buy, build, or improve the residence.
Acquisition debt can be excluded from tax under the Mortgage Forgiveness Debt Relief Act. Home equity debt cannot be excluded under this new law. Instead, home equity debt may qualify under the insolvency or bankruptcy exclusions.
There is one further criteria as well. The house must have been used as a main home, which means it was the principal place of residence for the debtor. That means second homes, vacation homes, investment properties, or rental units will not qualify under this exclusion. Canceled debts for those properties may qualify, however, under the insolvency or bankruptcy exclusions.
How much debt can be excluded from tax? Canceled mortgage debt of up to $2 million (or $1 million is married and filing a separate return) can be excluded from income for the years 2007 through 2013.
For more details, see an overview of the Mortgage Forgiveness Debt Relief Act, and a more detailed look at the Mortgage Forgiveness Debt Relief Act from the IRS Web site.
What all this means at a practical level, is taxpayers may need to document how their loan proceeds were used. That is, to separate acquisition debt from home equity debt.