The new law waives federal income tax on certain types of mortgage debt that might go away when a homeowner is foreclosed upon, sells the home for less than the outstanding debt (called a short sale), gives the lender a deed in lieu of foreclosure or gets a loan modification that reduces the outstanding balance.

Now for the fine print:

– The law only applies to mortgage debt that is forgiven in 2007, 2008 or 2009.

– Any amount of forgiven debt can be excluded from federal income, as long as the loan balance was less than $2 million ($1 million if married, filing separately).

– To qualify for the tax break, the borrower must have lived in the house as a primary residence. The law does not apply to vacation homes or investment property.

– The debt must have been used to buy, build or substantially improve the principal residence, or to refinance debt incurred for those purposes.

If you took out a home equity loan and used the money to buy a car or pay bills and the home equity loan is forgiven, you will owe tax on it.

Likewise, if you refinanced your home for more than the original balance and did not use the additional loan proceeds to improve the home, the extra amount would not qualify for the tax break.

– California has yet not conformed to the federal law. For now, California residents are subject to state income tax on debt that would have been taxed at the federal level if not for the new law.

Read the rest of the SF Gate article here