• The foreclosure is considered a disposition of the home for tax purposes, which results in a capital gain or loss. If the homeowner lived in the home in at least two of the five years preceding the foreclosure, up to $500,000 of gain for married taxpayers filing jointly or up to $250,000 of gain for single taxpayers can be excluded from income. Losses cannot be deducted on the taxpayer's tax return.

• If there is a cancellation of debt (COD) by the lender, the amount of the COD is taxable as ordinary income.

There are a couple of situations where the taxpayer does not have to include COD in ordinary income:

• The taxpayer is insolvent or in bankruptcy. Insolvent means that the taxpayer's debts exceed the fair market value of his/her assets, both before and after the debt is forgiven.

• The debt is nonrecourse debt. This means that the homeowner is not personally responsible for the debt. The only recourse to the lender is to sell the home.

In December 2007, the Mortgage Forgiveness Debt Relief Act of 2007 was enacted, which provides temporary relief for many taxpayers. This law excludes up to $2 million of COD income resulting from debt cancellation of qualified principal residence indebtedness for foreclosures between January 1, 2007 and December 31, 2009. Some of the major provisions include:

• Qualified principal residence indebtedness is debt incurred to acquire, construct, or improve a taxpayer's principal residence, if the debt is secured by the residence.

• The amount of COD excluded from income reduces the taxpayer's basis in the home. Thus, it will increase the capital gain or loss from the disposition. However, since those limits are so large, most taxpayers will probably not have a taxable capital gain.

• COD income from home-equity loan debt used for purposes other than to improve the principal residence is not excluded from income.

• Vacation homes and other real estate investments do not qualify for the COD income exclusion.