In the fuss and furor over whether or not Congress will act in time to prevent millions of Americans from getting hit with Alternative Minimum Tax next year, another piece of legislation that needs more attention isn't getting it. That's the Mortgage Relief Debt Forgiveness Act, which started off life as a separate bill but has since been folded into the same AMT relief bill Congress is trying to get passed right now.

The Mortgage Relief Act is aimed at helping people facing foreclosure on their principal homes, or those who are participating in short-sales. Under current law, when a homeowner owes more than the house is worth and loses the property in foreclosure, the excess is treated as income, and taxed that way.

For example, let's say a homeowner got a 125 percent loan on a $100,000 house. That means he owes $125,000 on a home worth only $100,000. If he subsequently loses the home to foreclosure, he will wind up with a debt forgiveness of $25,000. (He actually had $125,000 forgiven but the house's value offset $100,000 of that debt). The remaining $25,000 is considered income and he has to pay tax on it.

When adjustable mortgage rates adjusted and the foreclosure rate spiked, the sudden influx of homeowners facing this extra tax caught the attention of certain Congressmen. The members of the House supporting this legislation say that the tax is unfair, and adds insult to injury, says the House. But their proposed solution will impact other homeowners. If this bill becomes law, the principal residence tax loophole will change dramatically.

Right now if you live in your home for two of the previous five years you can exclude up to $500,000 of the gain on sale (married, filing jointly) or $250,000 if you file as single. This new law would require you to live in the home for all five years to get the full amount -- anything less would mean only receiving a pro-rata deduction.

I'm concerned that this bill is also going to hit other people, too. Homeowners who relocate and choose to rent out their existing home until the market comes back up will be especially hard hit. Now renting it out means turning tax free capital gains into taxable capital gains. And if you're subject to AMT you lose the lower 15 percent capital gains tax rate. Talk about a double whammy!

If this new bill becomes law, except for a ding to your credit, you'd be better off just letting the bank take the house back than going through the effort to rent it out and hang on until the market recovers. No tenant hassles. No bookkeeping work. And the government bails you out!

What exactly is the government trying to promote?

Published: November 27, 2007

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Diane Kennedy, the nation's pre-eminent tax strategist, is owner of Diane Kennedy & Associates, a leading tax strategy and accounting firm and founder of TaxLoopholes. She is the author of The Wall Street Journal and Business Week bestsellers, Loopholes of the Rich and Real Estate Loopholes, and co-author of The Insider's Guide to Real Estate Investing Loopholes, The Insider's Guide to Making Money in Real Estate, and TaxLoopholes for eBay Sellers. Register for free Tax Strategy updates and e-Newsletters delivered via email from TaxLoopholes.com. You will be updated on current tax law changes as well as proactive tax strategies the wealthy use plus news regarding Diane Kennedy.