With hundreds of thousands of homeowners having negotiated loan modifications or short sales or been foreclosed upon during the past year, the Internal Revenue Service has issued fresh guidance on how to handle canceled mortgage debt in the upcoming tax season. ...

... Usually, when a creditor cancels debts, such as unpaid balances on student loans or credit cards, the forgiven amounts are treated as ordinary, taxable income by the Internal Revenue Code. But under a special exemption adopted by Congress covering distressed home mortgages, many owners can escape the ultimate double whammy: getting hit with extra taxes because your mortgage went seriously delinquent or you lost your house.

In its latest guidance, the IRS focuses on several key points that owners — and former owners — need to know. Tops on the list: If a lender wrote off a portion of your mortgage debt, you don't automatically qualify for special tax treatment. To the contrary, there are essential tests you need to pass to qualify: The debt your lender canceled must have been used by you "to buy, build or substantially improve your principal residence." ...