President Bush signed into law the Mortgage Forgiveness Debt Relief Act of 2007, which is designed to relieve the stress many current home owners/sellers are feeling at the prospects of owing taxes on the "Phantom Income" earned when their debt is forgiven.  Whether through a foreclosure or a short sale, lenders usually end up forgiving the mortgage debt that was not repaid.  Under previous tax codes, this unpaid loan amount was considered a "gain" to the borrower and thus taxable "Phantom Income" at the tax payer's ordinary income tax rate.

The Debt Relief Act eliminates all or part of the tax consequences of forgiven mortgage debt for borrowers under very specific situations.  These rules must be met in order for the forgiven debt not to be a taxable event:

1. The debt must be discharged (forgiven) between January 1^st, 2007 and January 1^st, 2010. 
2. The property sold/foreclosed on must be the borrower's principal residence under the tax code, meaning the borrower must have lived in the home for a minimum of 2 of the previous 5 years.
3. The debt canceled must be "Qualified Principal Residence Indebtedness" which means that it is a loan that was used to acquire, construct or substantially improve a property. 

Thus, loans used to purchase 2^nd homes, investment real estate, etc do not qualify under this new provision. 

In addition, refinances usually only qualify up to the original amount borrowed to purchase the home.  For example, a borrower buys a principal residence for $450,000 by securing a loan for $400,000.  Later the home's value drops to $300,000 and is sold through a short sale for this amount.  Ignoring expenses, penalties, and any principle that may have been paid down, the lender has forgiven $100,000 in debt.  Under this scenario, the debt would not be taxable. 

However, assume this same principal residence was originally purchased for $300,000 with an original loan of $250,000.  The home appreciated to $450,000 and the homeowner refinanced for $400,000.  The value then drops back down to $300,000 and is sold for that amount with the lender forgiving $100,000 in debt.  Since the amount owed of $400,000 was greater than the original loan amount of $250,000, the first $150,000 in forgiven debt is taxable. 

There are other complicated rules governing the taxation (or not) of forgiven debt, so anyone finding themselves in this situation should consult their tax advisor or attorney for clarification in their specific situation.