Income tax generally applies to all forms of income, including cancellation-of-debt (COD) income. Think of it this way: If a creditor forgives a debt, you avoid the expense of making the payments, which increases your net income.
Debt forgiveness isn't the only way to generate a tax liability, though. You can have COD income if a creditor reduces the interest rate or gives you more time to pay. Calculating the amount of income can be complex, but essentially, by making it easier for you to repay the debt, the creditor confers a taxable economic benefit. You can also have COD income in connection with a mortgage foreclosure, including a short sale or deed in lieu of foreclosure.
Under the Mortgage Forgiveness Debt Relief Act of 2007, homeowners can exclude from their taxable income up to $2 million in COD income ($1 million for married taxpayers filing separately) in connection with qualified principal residence indebtedness (QPRI). But the exclusion is available only for debts forgiven (via foreclosure or restructuring) through 2012.
QPRI means debt used to buy, construct or substantially improve your principal residence, and it extends to the refinance of such debt. Relief isn't available for a second home, nor is it available for a home equity loan or cash-out refinancing to the extent the proceeds are used for purposes other than home improvement (such as paying off credit cards).
If you exclude COD income under this provision and continue to own your home, you must reduce your tax basis in the home by the amount of the exclusion. This may increase your taxable gains when you sell the home. Nevertheless, the exclusion likely will be beneficial because COD income is taxed at ordinary-income rates, rather than the lower long-term capital gains rates. Plus, it's generally better to defer tax when possible.
So if you're considering a mortgage foreclosure or restructuring in relation to your home, you may want to act before year end to take advantage of the COD income exclusion while it's available.