Forgiveness of debt means a bank or lender forgoes repayment of principal and/or interest that a borrower owes. Forgiven or discharged debt is typically considered ordinary income that is taxable.

But a new law, the Mortgage Forgiveness Debt Relief Act of 2007, now gives qualified taxpayers a three-year window to exclude discharged mortgage debt from their taxable income. In other words, if you find yourself doing a short sale on your principal residence, you are entitled to a reprieve from the tax liability.

To qualify:

• The debt must be discharged between January 1, 2007, and January 1, 2010.
• The amount of debt that can be excluded is limited to $2 million.
• The debt canceled must be a loan that was used to acquire, construct or substantially improve a property.
• The property must be the borrower's principal residence under the tax code, meaning the borrower must have lived in the home for at least two of the previous five years.
• Forgiveness of debt on vacation homes, second homes and investment property does not qualify.

EXAMPLE: If you bought a principal residence for $450,000 with a $400,000 loan and you sold the home in a short sale for $300,000, the lender discharged $100,000 in debt. You can exclude that amount.

NOTE: For debt forgiven on a cash-out refinance or home equity loan, only the amount borrowed to build, buy or improve the home can be excluded. Any money used for other purposes such as vacations, tuition or paying off credit card debt does not qualify.

Lenders are required to report forgiveness of debt to the Internal Revenue Service. Consult your tax advisor for more information.

Read FrontDoor.com's Top 10 Tax Tips for Homeowners:

1. Deduct mortgage interest and real estate taxes.
2. If you bought a home this year, deduct the points or origination fees.
3. For refinanced and second mortgages, deduct points equally over the life of the loan.
4. Deduct private mortgage insurance (PMI).
5. Deduct moving expenses if you moved at least 50 miles for a new job.
6. Up to $250,000 ($500,000 for married couples) is tax free when you sell your house.
7. Use home improvements and closing costs to offset your capital gains tax.
8. Exclude forgiven debt from taxable income.
9. Take advantage of energy efficiency tax credits.
10. Deduct damages to your home from disasters.

More on FrontDoor:

• FrontDoor's Top 10 Tips and Advice on Everything Real Estate
• Search Homes for Sale
• First-Time Homebuyer's Guide
• Foreclosure Buying Guide
• Home Seller's Guide
• Home Finance Guide
• Tools and Calculators

Comments