You can apply for income tax relief for up to $2 million (or $1 million if married and filing separately) in debt that is cancelled, or forgiven, by your mortgage lender on your primary residence. The law has been extended through 2012 under the Emergency Economic Stabilization Act. 
If you have lost your home through foreclosure or have restructured your mortgage loan, you may qualify for this tax relief under the extended tax law called the Mortgage Forgiveness Debt Relief Act of 2007. The claim can be made by using IRS Form 982.
There are two qualifying factors that must be met on the mortgage debt exclusion: 1) it must be your primary home, and 2) the debt must have been used to buy, build, or make substantial improvements to the residence to which the mortgage applies. Certain business or farm property may also qualify for tax-free treatment, so check with your accountant or tax attorney in this situation.
When a lender forgives debt, it is typically a taxable event. You would receive a 1099-C (Cancellation of Debt) and the income would be claimed on Line 21 on your personal 1040 income tax Form. (IRS Publication 525)
While mortgages for second homes and rental properties do not qualify for the exclusion, some or all of this debt might qualify for other exclusions if you are insolvent at the time the debt was settled.
Canceled credit debt does not have to be included in income if it was a gift, or if the individual is insolvent, or in a bankruptcy case. The exclusion for insolvency is particularly important in this case, because it will likely apply to borrowers with home equity loans or mortgages on second homes and rental properties, and will be helpful in this situation. This is an important point for borrowers whose property has dropped in value below what is owed on the mortgage.
According to the IRS, “A debtor is insolvent when, and to the extent, the debtor’s liabilities exceed the FMV (fair market value) of the assets. Determine the debtor’s liabilities and the FMV (fair market value) of the assets immediately before the cancellation of the debtor’s debt to determine whether or not the debtor is insolvent and the amount by which the debtor is insolvent.” (IRS Publication 908)
The value of all of your assets and all of the liabilities you owe have to be calculated to figure out if you are insolvent, and by what amount, so as always, check with your professional accountant to see how you can best take advantage of these tax relief measures for exclusions of cancelled or settled credit and mortgage debts.
REMINDER:
Corporate tax returns are due March 15th and extension deadline filing is September 15th
Personal tax returns are due April 15th and extension deadline filing is October 15th
