In December, President Bush signed into law The Mortgage Forgiveness Debt Relief Act which will help many taxpayers avoid the double whammy of losing their home in foreclosure or selling their home in a short sale - and finding themselves hit with a significant tax bill for forgiveness of debt income. Prior to the passage of this law, the dollar amount of the mortgage amount forgiven in a short sale or the gap between what the lender realized on the sale of the property after foreclosure and the mortgage debt and expenses and fees of foreclosures, would be reported on a 1099 to the IRS as forgiveness of debt income. The homeowner, unless able to demonstrate the he or she was insolvent at the time of the foreclosure or short sale, would owe federal income tax on the reported 1099 income.

The new law excludes income from the cancellation of debt due to foreclosure or short sale of a personal residence, but only to the extent the debt went into buying or improving the home. This income will be left out of taxable income if a foreclosure or short sale occurs between January 1, 2007, and December 31, 2009. Note that only loans used to buy or improve a primary residence are covered. If the loan proceeds were used for other purposes, the homeowner would still have forgiveness of debt income in connection with a foreclosure or short sale.