It’s January, which means it’s time to start thinking about filing your taxes. But you may need extra tax help this year, thanks to an active December on Capitol Hill.

In late December, President Bush signed the Mortgage Forgiveness Debt Relief Act of 2007, which provides tax help for homeowners facing foreclosure or who sell their homes in a short sale.

Previously, if the value of your home declined and your bank or lender forgave a portion of your mortgage debt, the tax code treated the amount forgiven as income that could be taxed, according to Eric L. Smith, a spokesman for the IRS.

In other words, if your lender forgave $20,000 in mortgage debt because your house was worth $20,000 less than your mortgage balance, the IRS treated this debt forgiveness the same as income that you earned from your job – and required you to add $20,000 in phantom income to the amount of your annual income and pay tax on it at your marginal tax rate.

Instead of getting tax help at a time of great need, you were getting a kick in the pants the following April 15th.

Under the new rule, taxpayers can exclude up to $2 million of mortgage debt forgiven in 2007, 2008, or 2009 on their principal residence. (The limit is $1 million for a married person filing a separate return.) According to Smith, mortgage debt reduced through restructuring, as well as mortgage debt forgiven in connection with a foreclosure, both qualify for the tax exclusion.

It’s worth noting that the Mortgage Forgiveness Debt Relief Act of 2007 only applies to principal residences, not second homes or investment property, says Chet Burgess, an enrolled agent who owns Brookwood Tax Services, in Atlanta. The rules from IRS Section 121 define what is a qualified principal residence, but at a baseline, you must live there the majority of the year.

The IRS doesn’t make it easy. You may need some additional tax help to be sure you’re filling out the forms correctly.

“The taxpayer will have to do some calculations on the side, off the tax return, in order to show the IRS how much has been forgiven,” Burgess explains.

When a lender forgives mortgage debt, the lender sends the taxpayer form 1099C or 1099A. The form should state the fair market value of the home. In the case of a short sale, Burgess says, that would be the sales price. In the case of a home that’s been foreclosed upon, the lender may just put the value of the loan in the field where the fair market value of the home should be listed. Or, the 1099C or 1099A form might not include a fair market value at all.

That’s a problem because that number is key to the off-the-return calculations you must complete and submit to the IRS.

“Let’s say someone buys a car for $10,000 and has a loan for the full amount. And let’s say on the day the car is repossessed it is worth $8,000. The lender might put $10,000 as the loan forgiveness amount, even though the car is actually worth $8,000. The amount of the loan forgiveness is just $2,000, not $10,000,” Burgess notes.

That’s why you need to know what is the fair market value of the property, and be able to document that for the IRS. In some cases, Burgess has advised clients to hire an appraiser to document the fair market value.

Here”s another important point: While the Mortgage Forgiveness Debt Relief Act of 2007 will allow loan forgiveness of up to $2 million on a primary residence, it’s only applicable to acquisition indebtedness, Burgess says.

“The amount of money it takes to buy your existing home, build a new home or the equity you cash out to make a substantial improvement to your home counts as acquisition indebtedness. But if someone took out $100,000 in home equity to buy a Hummer or send their kids to college, that doesn’t count,” he adds.

For example, let’s say 10 years ago you paid $100,000 for your house and got a 100 percent loan. Five years ago, the value of your home had doubled to $200,000. So you did a cash-out refinance for $150,000, and pocketed around $50,000. If you used that money to pay college tuition or buy a fancy fur coat, and then later sold your home for just $100,000, the $50,000 that your lender forgave would still be taxable. Why? Because you didn’t use the money to buy, build, or renovate your home.

How would the IRS know how you spent your cash? Burgess says you’re required to submit your tax calculations along with the 1099C or 1099A with your return. If you get audited, the IRS will want to see your original warranty deed or perhaps your original HUD-1 form (that lists where all of the cash goes in a transaction). If you used home equity money to renovate or improve the property, you’ll need to provide copies of cancelled checks, original receipts and invoices and other supporting documents.

For those homeowners who are facing foreclosure or a short sale this year, Burgess said the IRS had not, as of January 15th, come up with a way to report all of this on your federal income tax form.

His best advice: Use electronic tax preparation software this year. The private tax software companies have poured tremendous resources into getting their forms updated electronically.

Once you complete the tax software, print your completed tax forms and then attach your calculations and paperwork to your return.

“You’re supposed to be able to attach a PDF form with your statement to the efile return, but I’ve heard from other tax preparers that it doesn’t always work. In a case like this, I’d print the return to make sure that a human being is actually looking at each page to make sure everything is included,” Burgess advises.

The IRS pre-printed forms were printed last October, and do not reflect the new tax law changes. “In fact, some of the forms have not yet been approved for filing,” he says, noting that anyone subject to the alternative minimum tax (AMT) did not have the correct forms approved as of mid-January.

Next week: What happens if you don’t qualify for the Mortgage Forgiveness Debt Relief Act of 2007? There are some other options that may be available to you. We’ll look at those and go over other new home-related tax-law changes that may affect your return this year.

Published: Jan 24, 2008