What is the Mortgage Forgiveness Debt Act?

This was a law passed in 2007 to shelter homeowners in a foreclosure from "nasty tax surprises."

The act excludes from taxable income "most discharged primary residence purchase money debt" and provides some benefit to homeowners whose debt is a mix of refinance purchase money loans, home improvements, and refinanced consumer debt."

What does that mean? Well, normally if you have "discharge of indebtedness income" ("DOI"), that is, "income" that comes from the lender reducing the principal balance that you owe, this is called DOI income and this is taxable, believe it or not.

In other words, if you are in foreclosure and a part of the workout is that the lender reduces your principal, the difference between the amount your loan is reduced to and the amount you borrowed is DOI and that is taxable even if you are in foreclosure. The lender has to send you a 1099C and you have to file that with the IRS or face possible penalties and interest.

But, the good news is that the law has changed somewhat.

Ths new law applies to debt discharged between January 1, 2007 to December 3, 2009.

The new law makes an exception to DOI taxable income of up to $2 million for "qualified" principal residence indebtness. But only if the reason for the discharge of indebtedness is due to a decline in the residence's value, or the taxpayers financial condition.

Only funds used to acquire the home, or construct or substantially improve the home counts. (Acquisition debt.)

By the way, you do not owe DOI if you file bankruptcy, if the home was never worth the price you paid for it in the first place, or if the debt was "unconscionable" to begin with because of "usurious fees and rates."