Interesting article in the Washington Post:  IRS Kicks Homeowners While They Are Down, by Kenneth R. Harney:

For homeowners who are seriously delinquent on their mortgages and hoping for relief, the IRS 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….

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.