The tax consequence to which you have been referenced is "forgiveness of indebtedness income." When a lender accepts a reduced payment in satisfaction of a debt, the reduction may be treated as income to the debtor. If you do a "workout" with the bank by which it agrees to take less than is owed you may be able to avoid taxes under the Mortgage Forgiveness Debt Relief Act of 2007. This Act will provide relief from this additional tax in certain specified situations. Beginning January 1, 2007 and lasting until January 1, 2010, certain discharges of mortgage indebtedness on a principal residence will be excluded from a taxpayer's gross income.
Two principal restrictions apply. First, the relief is only applicable to indebtedness of less than $2,000,000. More importantly, the tax avoidance only applies to “acquisition” debt. Thus, owners who took advantage of increased home values to refinance larger amounts may find that they may not take advantage of this change in the law. If, under a workout, you keep the home but pay a reduced mortgage, rather than incurring income, the reduction is used to reduce the cost basis of your home.
I am a bankruptcy attorney here in Arizona and this is an extremely common question here.
Arizona is an anti-deficiency state and our state statutes prevent the creditors from coming after homeowners in the event of a foreclosure. Since the creditors have no recourse for the deficiency in our state, there is no forgiveness of debt income.
Another option you might be able to consider is to strip off any junior liens in a Chapter 13 bankruptcy. If you have a first mortgage and a junior mortgage and your house is worth less than your first, the second can be stripped off in a Chapter 13 bankruptcy.
Call me if you have any questions.