When you fall behind on your mortgage and slip toward losing your house to foreclosure or a "short sale," should you have to worry about the IRS whacking you with extra taxes?
The answer unfortunately is yes -- if your lender forgives any of your mortgage debt as part of a workout arrangement, short sale or other accommodation. It's a problem that is beginning to affect thousands of financially-distressed homeowners who signed up in recent years for loans with payment "resets" they couldn't afford. Now that they are falling behind on payments -- one of every seven subprime borrowers is in default, according to the Mortgage Bankers Association of America -- their lenders are custom-crafting "loss-mitigation" solutions that either restructure the loan, reduce the principal balance, or in more troubled situations, sell the property in advance of foreclosure proceedings.

Under the Internal Revenue Code, however, any forgiveness of mortgage debt is considered to be receipt of income, fully taxable at regular rates. Even if you've just lost everything -- your equity, your house, your credit standing -- the IRS will come after you for its pound of flesh. If your pre-foreclosure short sale produced $10,000 less in net proceeds than you owe your lender, and your lender agrees to cancel that balance, the IRS will hit you for taxes on the $10,000.

The IRS typically learns about the debt cancellation from your lender, who is required by law to report such transactions using Form 1099-C.

But the hardball "smack-em-while-they're-down" approach by the IRS might be in for a change. New, bipartisan legislation would exempt all debt forgiveness on primary home mortgages from treatment as income by the IRS. The Mortgage Cancellation Relief Act of 2007 (H.R. 1876) is co-sponsored by Rep. Robert E. Andrews, a New Jersey Democrat, and Rep. Ron Lewis, a Kentucky Republican. The bill is now before the House Ways and Means committee, and could play an important role in Congressional efforts to help assist delinquent and distressed subprime homeowners nationwide.

Diane Thompson, a legal services attorney based in East St. Louis, Ill., says obtaining relief from IRS tax demands "is crucially important" to anyone seeking to avoid foreclosure and work things out with a lender. She described the case of one homeowner who spent months negotiating a workout accommodation with her mortgage lender, including a forgiveness of a portion of her debt. The IRS subsequently hit her with a lump-sum tax demand that exceeded her annual income.

The Andrews-Lewis bill would eliminate some of the problems facing such borrowers, but not all as currently drafted, said Thompson. For example, it would not cover second liens on the house-a commonplace situation in many parts of the country where "piggyback" combinations of first and second liens were popular during the housing boom years. Also, many low-income borrowers obtain "soft seconds" in order to finance needed repairs to their homes. Under the bill, they could face taxes on those seconds when they are wiped out by termination of the primary lien through a short sale or deed-in-lieu of foreclosure.

The debt cancellation relief bill has the strong endorsement of the National Association of Realtors, and is rated a good bet to get serious consideration in the coming months.