On December 20, 2007 President Bush signed the Mortgage Forgiveness Debt Relief Act of 2007. The new law passed and has received a substantial amount of press, because of the mortgage credit crisis and the tremendous growth in foreclosures in 2007. It offers some income tax relief to homeowners who are unable to pay their mortgage liabilities.

The general rule of law is that a forgiveness of debt results in taxable income to the person owing the debt. The example that everyone has recently become familiar with is the homeowner who cannot afford to keep up his mortgage payments, but who cannot sell the house for enough to pay off the mortgage. Such individuals some times negotiate with their mortgage company what is called a "short sale. " In a short sale a mortgage company agrees to accept what the homeowner can get for selling the house in full satisfaction of the mortgage. For example if a mortgage balance is $200,000.00, and the house will only sell for $180,000.00 the mortgage company may agree to accept $165,000.00 (this example assumes that the cost of selling the house such as realtor fees, transfer taxes and title insurance adds up to $15,000.00).

In this short sale example the mortgage company will lose $35,000.00 and will agree not to pursue the homeowner for the deficiency. The mortgage company accepts the deal, because they would have lost more money in a foreclosure proceeding. Although the homeowner walks away with nothing, he or she accepts the deal, because she can avoid owing the balance of the mortgage debt that the sale failed to pay off.

Unfortunately the seller of the property who has just lost his home will have $35,000.00 of taxable income. Furthermore, many people entering short sales are not aware of this law, and they only discover their liability, when they receive a letter from the IRS informing them that they failed to pay thousands of dollars of taxes, penalties and interest on their tax returns.

The Mortgage Forgiveness Debt Relief Act of 2007 does remove the tax liability for people going through home foreclosures and short sales, although the law fails to cover all situations. For one thing the act is a temporary law. It only covers the three year period of 2007 thru 2009. Furthermore, it only covers home acquisition financing, not home equity financing.

Example. Harry Hedger buys a house in 2004 for $250,000.00 with no money down. In 2006 he refinances the home for $300,000.00; so he may take advantage of a hot stock market tip. Unfortunately, the stock investment turns South, and in 2007 he sells his home in a short sale which nets $230,000.00 to the mortgage company. Harry's debt forgiveness is $70,000.00. $20,000.00 of this amount will be tax free, because it is home acquisition indebtedness, but he will still have $50,000.00 of taxable income.

Finally, the new law applies only to a taxpayer's principal residence and thus does not help an investor or vacation home owner who loses her property.

One important point to keep in mind is that even without the new law there were two important exceptions to the debt forgiveness provisions even before the president signed the new law. The taxpayer will not have debt forgiveness income, if he went bankrupt, or if the forgiveness of the debt left him insolvent. When bankruptcy occurs most taxpayers know they have filed bankruptcy. Insolvency occurs when a person's debt exceeds their property. Many people who lose their homes in foreclosures in fact qualify for the insolvency exception, but unfortunately insolvency is harder to define than bankruptcy, and many individuals overlook the potential benefit, because in their distressed financial condition they do not feel they can afford to hire a CPA or a tax attorney with a sophisticated knowledge of the tax law.

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