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This relief from tax is explained on the IRS web site “The Mortgage Forgiveness Debt Relief Act and Debt Cancellation”

Here is the IRS publication on Canceled Debts, Foreclosures, Repossessions,and Abandonments.

In my May 4, 2007 TGIF Legal Tip: Short Sale – Seller Perspective, I wrote:

There is pending legislation in Congress to amend the Internal Revenue Code of 1986 to exclude from gross income of individual taxpayers discharges of indebtedness attributable to certain forgiven residential mortgae obligations.  It was introduced in April 2007, but there has not been any recent activity as of August 2007.

Well, on December 14, 2007, drum role please,  it passed both houses.  [See GovTrack.us update].

The bill may now proceed to a conference committee of senators and representatives to work out differences in the versions of the bill each chamber approved. The bill then goes to the President before becoming law.

What it can do is allow an individual to not have pay taxes on debt forgiveness on the short sale of a principal residence.  This ONLY applies to a principal residence or a home you have lived in for part of the last 5 years (partial exclusion of the income is possible.)  It does not apply to investment property.

There is also a Review Journal article that can be found in the December 19th 2007 Business Section.

If you would like you can contact the comment line of the Honorable President of the United States George W. Bush at 202-456-1111 and comment that H.R. 3648: Mortgage Forgiveness Debt Relief Act of 2007 should be signed into law.  You can also email the President of the United States at comments@whitehouse.gov . 

[UPDATE 12/21/2007] Well apparently your calls worked, the President signed the bill on December 20, 2007 so as they say in “School House Rock,” ….”Mr. Bill, you are a Law!”