Although the 2007 law that allows taxpayers to exclude from income the amount of debt that is forgiven or canceled by their lender doesn't expire until December 2012, it's likely to take every bit of the remaining months for financially troubled homeowners to persuade their banks to either foreclose or allow their houses to be sold for less than the loans on them.

Although owners who are struggling to hold on to their homes shouldn't throw in the towel solely because of the pending tax bite, it is certainly something to consider.

Under the tax code, borrowed money need not be reported as income because you have an obligation to repay. But if the lender subsequently cancels what you owe, the IRS requires that you report that debt as income because the duty to repay it no longer exists.

So, if you owe 250,000 on a mortgage and your lender "forgives" 50,000 of that debt in a 200,000 refinance or sale, that 50,000 is considered income. If your combined federal and state marginal tax rate is 36%, you would owe 18,000 in taxes.

Under the Mortgage Forgiveness Debt Relief Act of 2007 though, taxpayers are allowed to exclude from income this discharge of debt on their principal residence - at least until January 1, 2013.

So when your lender agrees to a short sale, there is no tax on the difference between the selling price and the amount you owe. When your lender forecloses, there is now no tax on the canceled debt. Even when you refinance at a lower loan balance, there is no tax on the difference between what you owed on the old loan and what you owe on the new one.

Source: http://www.latimes.com/

(Sylvia's Note: It is recommended that you consult a qualified tax professional to determine your tax liability in your specific case)