Federal law states that taxable income is recognized when debt is discharged. If a lender forgives debt you owe, you will have income to the extent your debt has been canceled. That applies to real estate mortgages.
Suppose you own a house with a $300,000 mortgage, and you sell it for $250,000, in today’s weak market. If the lender accepts that $250,000 and cancels your obligation, you’d pick up $50,000 in “cancellation of debt” income.
A new law takes you off the hook, at least for now. For discharges of home mortgage debt from the beginning of 2007 through 2009, no income tax will be due. (This tax shelter is capped at $2 million of cancelled debt.)
This tax break applies only to debt used to acquire, construct, or improve your principal residence, and the debt must be secured by that residence. Thus, there is no relief for discharge of a home equity loan, unless you used the proceeds for home improvements. Similarly, you will own income tax on debt relief related to a secondary home or investment property.
