Previously, if a lender forgave all or part of a mortgage, the borrower was considered to have received taxable income

Currently, a taxpayer may exclude up to $2 million of income from the debt on a principal residence that is forgiven during the years 2007 through 2012. This includes a mortgage refinance as well as a foreclosure.

(CAUTION: DON’T confuse this with future liability for the debt itself vs taxation….you may still find the bank hooking up to the family car in the middle of the night 5 or 10 years out, yes it does happen regularly !)

The rule applies only to acquisition indebtedness, which would be funds for the purchase or improvement of the home. Home equity loans not used for improvements do not receive the benefit.

The lender who forgives a mortgage must send the taxpayer a Form 1099C or 1099A that should show the fair market value of the home and the amount of the loan. The difference would normally be the income received. If audited, the taxpayer will have to document that funds were spent for the purchase or improvement of the home.

More:

U.S. Internal Revenue Service (The Mortgage Forgiveness Debt Relief Act and Debt Cancellation):

http://www.irs.gov/individuals/article/0,,id=179414,00.html