Just like a scene from the Wizard of Oz, the last few years of turmoil in the real estate market seem more fictional than real. Many taxpayers have lost their homes or investment properties to foreclosure or short sales. As I meet with clients who have lost homes, I often get the BIG question: “Do I have to pay taxes on the money that was written off by the bank?”

In case you didn’t know, the IRS considers forgiveness of debt a taxable event and requires a lender to send a 1099-C to the taxpayer in affect giving them taxable income.

If your mortgage debt is partly or entirely forgiven during tax years 2007–2012, you may be able to claim special tax relief and exclude the debt forgiveness income. Under the Mortgage Forgiveness Debt Relief Act of 2007 and Emergency Economic Stabilization Act of 2008, you may be able to exclude up to $2 million of debt forgiven on your principal residence (the limit is $1 million for a married person filing a separate return). Taxpayers may also exclude debt reduced through mortgage restructuring, as well as mortgage debt forgiven in a foreclosure. To qualify, the debt must have been used to buy, build or substantially improve your principal residence and be secured by that residence. Refinanced debt proceeds used for the purpose of substantially improving your principle residence also qualify for the exclusion. However, proceeds of refinanced debt used for other purposes (for example, to pay off credit card debt) do not qualify for the exclusion.

These days putting on your ruby red slippers and clicking your heels will not get you an IRS tax exemption. Like most good tax breaks, you need to actually file a tax return and claim the exemptions. If you qualify, you can claim the special exclusion by filling out Form 982 Reduction of Tax Attributes Due to Discharge of Indebtedness and attaching the form to your federal income tax return for the year of discharge.

“What if it is not my primary residence I lost?”

Debt forgiven on second homes, rental property, business property, credit cards or car loans does not qualify for the Mortgage Forgiveness Debt Relief Act of 2007. However, other tax relief opportunities may be available. One exemption available to taxpayers is the insolvency exemption. The idea behind this exemption is if a taxpayer’s liabilities are greater than his or her assets, he or she does not have the funds to pay taxes. Business real property debt may be partially or fully excludable under the insolvency exemption. To find out how much can be excluded from taxable income, the taxpayer must do a detailed computation of his or her assets and liabilities. Debt cancelled in a bankruptcy is not taxable.

Filling out the forms and computations can be a challenge. To determine if you qualify for some tax relief under the Internal Revenue Code contact a CPA or other tax professional who is experienced with these tax exemptions.