Debt forgiveness usually is considered taxable income. However, under the Mortgage Forgiveness Debt Relief Act of 2007, you may be able to exclude up to $2 million of debt forgiven on your principal residence in 2007-2012 ($1 million for married filing separate). 

You may exclude debt reduced through mortgage restructuring, as well as mortgage debt forgiven in a foreclosure. To qualify, the debt must have been for buying, building or substantially improving your principal residence, and the debt must have been secured by that residence. Refinanced debt used for other purposes, such as to pay off credit card debt, does not qualify for the exclusion.

If your debt is reduced or forgiven you will receive a year-end statement, Form 1099-C, from your lender. By law, this form must show the amount of debt forgiven and the fair market value of any property foreclosed. The IRS urges borrowers to examine the Form 1099-C carefully. Notify the lender immediately of any mistakes, especially on the amount of debt forgiven (Box 2) and the value listed for your home (Box 7).

If you qualify, you claim the exclusion by filling out Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, and attaching it to your federal tax return for the year.