To say it has been a rough few years in the housing market is like saying there was a small party in New Orleans after the Saints won the Super Bowl. The housing bubble didn’t burst. It blew up like a hydrogen bomb. Unfortunately, this has resulted in many people losing their homes through foreclosure or short sales. Both events have tax consequences.

The pure strangeness of the federal tax code has been commented on repeatedly by many people. Perhaps no where is it stranger than when considering how to handle debt that is forgiven. How so? Well, the tax code is set up in such a way that it considers the relief of debt as…income. Yes, you read that right. If I owe $100,000 on my home and short sell it for $50,000 less than what I owe, I technically have a gain of $50,000 on my income and must pay taxes on it.

Now the government has recognized that most people are in bad shape if they lose their homes. As a result, they’ve come up with a bit of legislation that helps people avoid the income tax consequences of mortgage debt forgiveness for the years 2007 through 2012. The legislation is known as the Mortgage Forgiveness Debt Relief Act of 2007.

The process works fairly simply. You can avoid paying income tax on up to one million dollars in mortgage debt forgiven as a single individual or two million as a married couple. The debt must be applicable to your primary home. It applies to the money used to buy or build the home. It also applies to any refinance debt that was used to improve the home. Refinance money that was used for other purposes is not covered.

To claim the exemption, you need to fill out Form 982. You should also receive a 1099-C from the lender in question. Make sure you check it closely to affirm that the numbers reported are correct.