In response to the housing crisis and a still shaky economy, Congress is making changes to the tax code. One such revision is an amendment that helps millions of home sellers who owe more on their mortgages than their dwellings are worth—a condition known as being upside down or underwater. The legislation significantly benefits some upside-downers while doing nothing for others.

Internal Revenue Code Section 61(a)(12) requires debtors to report all forgiven debts on their 1040 forms, the same as income from salaries or investments. The IRS taxes forgiven amounts at the rates for ordinary income from sources like salaries. Some forgiven debts sidestep taxes. Section 108 specifies several carefully hedged exceptions, including bankruptcies (Chapter 11 cases) and insolvencies (liabilities exceed assets).

Section 108's newest exception benefits those whose debts are reduced or canceled in mortgage meltdown transactions-"mods," foreclosures, deeds in lieu of foreclosure and short sales. Lawmakers first allowed special relief for debts eliminated during 2007, 2008 and 2009 (Mortgage Forgiveness Debt Relief Act of 2007), but later extended relief through 2012 (Emergency Economic Stabilization Act of 2008).

QUALIFYING FOR RELIEF

For example, suppose Sue Smith disposes of her residence in a lender-okayed short sale that erases the unpaid part of her mortgage. Or suppose the lending company forecloses, subsequently sells and cancels a portion of her debt. Generally, the tax code calls for Sue to report partially or entirely forgiven amounts on her 1040 form. No more. Legislation allows home sellers like Sue to exclude as much as $2 million of canceled debt.

Sue must satisfy two stipulations in order to sidestep such taxes. First, the security for her mortgage must be her principal residence. Second, she must have incurred the debt to buy, build or substantially improve that residence. There's no relief for Sue's home equity loans or cash-out refinancings, except to the extent that she used the proceeds to make improvements. Fine print also prohibits relief if lenders forgive debts on second homes or rental properties.

Whether a property qualifies as a principal residence depends on the case. If, for instance, Margo Harrington resides at more than one property, the IRS treats the property she uses the majority of the year as her principal residence for that year. It takes other factors into account too, including her place of employment; the principal place her family lives; the mailing address she uses on her tax returns, driver's license, automobile registration and and other papers; and locations of religious organizations and recreational clubs she's affiliated with.

The IRS still duns Margo and other debtors for taxes on all other forgiven debts like those on second homes, rental or business properties, credit cards and car loans. Margo may qualify for other relief, though, such as insolvency.

EXCLUSION LIMIT

Section 108(a)(1)(E) caps the amount of forgiven indebtedness homeowners are allowed to exclude from income for all of the years 2007 to 2012, not for each one. For married persons filing jointly and single persons, it's $2 million of income from the discharge of qualified principal residence indebtedness (QPRI). For married persons filing separate returns, the limit drops to $1 million. Forgiveness in excess of $2 million (or $1 million) remains taxable. The revised Section 108 allows an exclusion only for acquisition indebtedness. This means mortgages taken out by owners to buy, build or substantially improve their principal residences or main homes. And the residences are the securities for the debts.

Section 108 also okays an exclusion for debt reduced through mortgage restructuring, and for debt used to refinance QPRI. Here, there's relief only up to the amount of the old mortgage principal, just before the refinancing.

Another constraint is that the exclusion does not help homeowners who took advantage of the run-up in real estate prices to do cash-out refinancing, in which they didn't use the funds for renovations of their primary residences and instead used them to pay off credit card debts, tuition charges, medical expenses or certain other expenditures. This last category of prohibited outlays includes basic repairs that keep a home in good condition, but don't add to its value or prolong its life. For instance, repainting a house, fixing gutters or floors, repairing leaks or plastering, or replacing broken window panes.

Let's say Alexander Vennebush bought a residence for $315,000, making a down payment of $15,000 and taking out a $300,000 mortgage on which he was personally liable and which was secured by the home. The following year, Alex took out a second mortgage loan of $50,000 that he used to add a garage to his home.

When the home's market value was $430,000 and the outstanding principal of his first and second mortgage loans was $325,000, Alex refinanced the two loans into one of $400,000. He used the additional $75,000 debt (the amount by which the $400,000 new mortgage loan exceeded the $325,000 outstanding principal balances of both mortgage loans immediately before the refinancing) to pay off personal credit cards and his daughter's tuition. For exclusion purposes, Alex's post-refinancing QPRI is just $325,000 since the $400,000 qualifies as QPRI only to the extent it does not exceed the $325,000 refinanced debt.