Mary and John Smith bought their home in 2005 for $300,000. They got 100% financing and an adjustable rate mortgage starting at 4.5% with monthly payments of just over $1,500. In 2007, their interest rate adjusted up to 6.5%, increasing their monthly payment almost $400. For a couple of months they struggled with the increase, but finally they realized that they could no longer afford the payments. So they decided to sell their home.
Unfortunately, their house was now worth only $250,000, $50,000 less than their mortgage. They called their bank and explained the situation. The bank realized that if they had to foreclose on the Smiths, the cost of the foreclosure would be more than the $50,000 they would lose if they let the Smiths sell the home for its lowered value. So the bank agreed to accept a "short sale". They would let the Smiths sell the home for less than the $300,000 loan, and the proceeds from that sale would be accepted as payment in full for the $300,000 loan. The Smiths thought they were lucky to have a bank that was willing to release them from their $300,000 liability for only $250,000. And they felt even luckier when they actually found a buyer for their home.
But their luck ran out with the IRS. The IRS looked at the short sale and said that the $50,000 difference between what the Smiths owed the bank ($300,000) and what they gave the bank ($250,000) was, in the eyes of the IRS, forgiveness of debt and, therefore, should be counted as income. They demanded that the Smiths pay taxes on the $50,000 "income", even though the Smiths never received the money!
The unfairness of this was so clear that Congress passed, and the President signed, the Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648). For those homeowners who qualify, they are relieved of this tax liability. The bill is effective retroactively for debt discharged from January 1, 2007 through December 31, 2009. The Act deals only with personal residences where debt is discharged through foreclosure, short sale, renegotiations, etc. And for those who keep their homes put pay mortgage insurance, it also extends the tax deduction for payment of governmental and private mortgage insurance for another three years.
Check with your tax advisor or read the full text of the Act to see if you qualify. It may not allow you to keep your home, but at least it won't be adding insult to injury by having you pay taxes on "income" you never received.