UPDATE: The exclusion discussed in this post has been extended through 2013
If foreclosure, repossession, short sale, loan modification (not with original lender) or walking away from your home is a REAL possibility in the next few months, then it may behoove you to get it done sooner rather than later. Now I'm not suggesting that it's a good idea to abandon your mortgage, but, if it's going to happen anyway, there are real issues that affect the timeliness.
As a result of the mortgage crisis, Congress enacted a new exclusion for income from Qualified Personal Residence Indebtedness. In a nutshell, this means that if your home is foreclosed, repossessed, short sold, or loan modified, AND, you were personally liable for the loan portion not recovered by selling your property, you didn't have to pay taxes on up to 2 million dollars of cancelled debt that the bank did not recover. (1 million if Married Filing Separately.) If you aren't personally liable for the rest of the loan, are losing the home in bankruptcy, or your negative net worth exceeds the cancelled debt, you don't have to claim it as income anyway. Otherwise, be aware of this:
The rule that allows you to exclude the cancelled debt on a personal residence is set to expire at the end of 2012. UPDATE: The exclusion has been extended through 2013
If your home is foreclosed after that, and Congress doesn't extend the exclusion, you could be stuck with a large tax bill.
Now before you rush out and hand the keys to your lender, talk to your Tax Guy. This is a complicated issue that I have GROSSLY oversimplified. But do it now.
As always I am available to answer any questions you may have vis email: email@example.com and feel free to share this with anyone who might be in trouble with their mortgage.
Here's a little light reading on Cancellation of Debt: