Dear Tax Talk:
I live in Arizona. I am currently $100,000 upside down in my house and have significant credit card debt. I was laid off from my job and fell behind. I recently put it up for sale as a short sale.

What should I do to try and avoid the tax ramifications due to the short sale? The real estate agent says the president has implemented something where the IRS will not go after people who do short sales on their property?
-- Denise

Dear Denise,
You may be off the hook from the IRS, but the lender will certainly want its money if it can get it. When you borrow money, it is not considered income. When you fail to repay the debt, you have income.

The Mortgage Forgiveness Debt Relief Act of 2007 allows individuals to exclude from gross income a discharge of qualified principal residence indebtedness. Qualified principal residence indebtedness is a mortgage you took out to buy, build or substantially improve your principal residence.

If the amount of your original mortgage is more than the cost of your principal residence plus the cost of any substantial improvements, only the debt that is not more than the cost of your principal residence plus improvements is qualified principal residence indebtedness.

Any debt secured by your principal residence that you use to refinance qualified principal residence indebtedness is treated as qualified principal residence indebtedness, but only up to the amount of the old mortgage principal just before the refinancing.

For example, if you refinanced your home and took out cash to use for other purposes (such as to consolidate credit card debt or buy a car), the cash-out part of the debt would not qualify for exclusion under these rules. If you're in this situation, other rules relating to insolvent or bankrupt taxpayers may keep you from recognizing income.

Your principal residence is the home where you ordinarily live most of the time. You can have only one principal residence at any one time. You do not have to have lived in and owned the home for two years for it to be your principal residence.

To claim the exclusion, you must file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), with your tax return.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.

To ask a question on Tax Talk, go to the "Ask the Experts" page, and select "taxes" as the topic.