Are you one of the scores of homeowners who are considering walking away from a mortgage you can’t afford? Or maybe your lender has agreed to a short sale as a way to get the property off their books. Before you make either of these moves, you better understand the tax ramifications. Otherwise, you could end up with a big, fat bill from the IRS. In a nutshell, here’s the rule: If you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled amount as income for tax purposes, depending on the circumstances. For example, suppose you borrow $10,000 and default on the loan after paying back $2,000. If the lender is unable to collect the remaining debt from you, there is a cancellation in debt of $8,000, which generally is taxable income to you. Meaning if you’re in the 20% tax bracket, you’ll have to cough up another $1,600 for taxes. But thanks to the Mortgage Forgiveness Debt Relief Act of 2007, there are exceptions that might apply to you. The most notable is that the amount forgiven on a mortgage for a principal residence is exempt up to $2 million or $1 million if married filing separately. So for most people, they won’t have a tax problem. However, before you breathe a sigh of relief, make sure the home is your principal residence. Because borrowers who don’t live in the house they’ve mortgaged could find themselves in a real pickle. Let me give you a real life example: I have a close friend who got caught up in the real estate frenzy back in 2004 and 2005. He and his growing family lived a small house that was complete paid for and probably worth $75,000 before the bubble hit. In a few years, it had shot up to over $300,000. That’s when they decided to buy a bigger home in a nicer neighborhood. They got hooked up with a mortgage broker who conned them into a couple of suicide loans. And like magic, they were in the new home with nothing down and without selling the old house! What happened next could be the plot for a Stephen King novel ... His interest rates skyrocketed, now he can barely make the payment on the new house. And as far as the old house goes: His tenant moved out, and he’s stuck with a $300,000 mortgage on a house that’s worth about $90,000. He’s trying to get the bank to reduce the principal owned. But they won’t budge. The best they’ll do is stay with the original teaser interest rate. So there the place sits … no one living in it and the mortgage not getting paid. Mail them the keys, and forgetting about the whole thing is one option he’s considering. But look at the potential tax liability since the house is not their primary residence: $300,000 owed minus the $90,000 selling price = $210,000 forgiven At a 30% tax rate, he might have to come up with $70,000 to pay the IRS. He doesn’t have that kind of money. And if he did, he sure wouldn’t want to use it to pay taxes. I told him that he needs to get in touch a good tax attorney to see if there is anyway to cut a deal with the IRS. Bankruptcy is always a last resort. So if you find yourself in similar jam, be sure to get expert advice before you drop the key in the mailbox. Otherwise you may find Geithner’s posse at your doorstep. And for the complete story on canceled debts, go to IRS Publication 4681. Best wishes, George P.S. I’m now on Twitter. Follow me at http://twitter.com/efinancialwrite for frequent updates, personal insights and observations on how to have a healthy retirement. If you don’t have a Twitter account, sign up today at http://www.twitter.com/signup and then click on the ‘Follow’ button from http://twitter.com/efinancialwrite to receive updates on either your cell phone or Twitter page.