For homeowners who are seriously delinquent on their mortgages and hoping for relief, the Internal Revenue Service has bad news: If your lender agrees to modify your loan and forgive any of your debt, you could owe federal income tax on the amount forgiven.

Think of it as the tax code's "kick 'em while they're down" rule. When personal debts are canceled by a creditor, the amount forgiven is treated as ordinary income under the Internal Revenue Code, except in some situations such as insolvency. Worse yet, the lender is required by law to report the canceled amount to the IRS.

Ouch! This is especially bad news for the growing numbers of credit-impaired subprime borrowers who find themselves "upside down" in the current real estate market: They owe more on their mortgage than the value of their house, thanks to noxious combinations of zero down payments, declining property values and hefty payment increases they can't afford.

Diane Thompson, a lawyer with the Land of Lincoln Legal Assistance Foundation in East St. Louis, Ill., tells of one client who learned about the tax code's Catch-22 the hard way. After the homeowner negotiated a loan modification agreement with her lender, she assumed that she was done with the matter. But a year later, the IRS came after her, demanding a large tax payment on the amount the lender forgave -- a tax bill that was equal to her annual income. As required, her lender had dutifully submitted a Form 1099-C to the IRS, alerting the agency to the woman's extra "income" from the loan modification.

The homeowner never received that income in any tangible way; she couldn't deposit it in her bank account. But under federal law, the IRS had every right to come after her for unpaid taxes.

Similar situations are likely to pop up around the country in the coming year as lenders bend over backward to modify thousands of troubled loans to prevent foreclosure. Proposed legislation on Capitol Hill could soften some of the impact on financially stressed homeowners, however. The Mortgage Cancellation Tax Relief Act of 2007 (H.R. 1876) would amend the tax code to exclude debt forgiveness on principal home mortgages from treatment as income.

Introduced in mid-April by Reps. Robert E. Andrews (D-N.J.) and Ron Lewis (R-Ky.), the bill would allow lenders to restructure delinquent mortgages without worrying about income-tax hand grenades hitting their borrowers the next year. The legislation could assist many other homeowners in financial trouble who negotiate pre-foreclosure "short sales" or deeds in lieu of foreclosure, or those whose foreclosure proceeds are insufficient to pay off their mortgage debt.

Short sales are increasingly commonplace. Say you are seriously behind on your mortgage payments, and a loan modification or rate reduction won't solve the problem because you have lost your job. As an alternative to foreclosure, your lender might suggest a quick sale of the house, often to an investor who will buy it as-is at a discounted price. If the short sale proceeds are $10,000 less than the outstanding mortgage balance and your lender agrees to forgive that amount, the Andrews-Lewis bill would allow you to obtain that relief tax-free.

Under current law, your lender would be required to report the $10,000 in phantom income to the IRS. Ditto if you went to foreclosure and the sale proceeds yielded $10,000 -- or $50,000 -- less than the outstanding debt owed to the lender.

Proponents of the debt-relief bill argue that short sales, mortgage delinquencies and foreclosures are painful situations for most homeowners and that there's no public policy purpose served by smacking them with tax penalties that make things even worse. In the case of below-market short sales, for example, most homeowners have already suffered sizable capital losses that are not tax-deductible. They've lost thousands of dollars in equity.

Why pile on?

The outlook for the bill: It's currently before the House Ways and Means Committee, Congress's primary tax legislation body. Because most of the majority-Democratic housing and banking committee leaders have called on banks and mortgage companies to work out solutions to keep troubled homeowners out of foreclosure, a bipartisan tax fairness bill like this one should have a reasonable chance of passage.

Kenneth R. Harney's e-mail address is KenHarney@earthlink.net.