Prior to the passage of The Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648), any portion of mortgage debt that was forgiven (either through a loan modification, short-refinance, short-sale, deed-in-lieu of foreclosure or foreclosure) was treated as taxable income.

The Mortgage Forgiveness Debt Relief Act will save some homeowners who negotiated a loan modification, are selling as a "short sale" or whose home as been foreclosed upon from paying federal income taxes on the "forgiven" (i.e. unpaid) debt.  There are very specific requirements*:

The mortgage is on the homeowner's primary residence. 

The relief does not apply to debt forgiveness on a vacation or investment home.

Forgiveness is for the "acquisition indebtedness" of the primary residence. 

Acquisition indebtedness is defined as "the debt used to purchase, construct or rehabilitate the home."

No relief is available for the cash-out portion of the mortgage

Whether the cash-out takes the form of a refinanced first mortgage, a second mortgage, a home equity line or similar arrangement.  Exception:  if the cash-out was specifically used to improve the home and the homeowner has adequate records to prove it.

Important note for California residents:  This Act relieves these specific homeowners of their federal tax liability but does not relieve homeowners from their California income tax liability. 

The Conformity Act of 2010

On April 12, 2010, SB 401 the Conformity Act of 2010 was enacted in California.  In general, it allows certain taxpayers who had all or part of the loan balance on their principal residence forgiven by their lender to exclude the forgiven debt from California gross income.  The new law applies to discharges of principal residence indebtedness (as defined) on or after January 1, 2009 through December 13, 2013.  Whether or not you qualify can only be determined by your attorney or tax advisor.