The year 2007 was dominated by housing woes. Many individuals who took out adjustable-rate mortgages to buy homes discovered that those loan terms, a changing economy and slumping housing market combined into a perfect homeownership storm.

Many individuals lost their houses to foreclosure; others were able to renegotiate more manageable payment terms. But in both cases, many of those homeowners soon discovered that they also owed unexpected taxes related to their real estate transactions.

Tax laws consider debt that a lender forgives as taxable income. In a homeowner's case, for example, if the bank reworks a loan so that the principal is less and writes off that excess, the amount is taxable cancellation of debt income. The same is true in certain situations where a mortgage lender forecloses on a home and sells it for less than the owner's loan principal. For example, if a bank forecloses when the borrower owes $400,000 on a home and then sells the property for $310,000 in full satisfaction of the debt, the borrower will usually owe tax on $90,000.

Although the taxability of debt forgiveness amounts has long been on the tax books, it came as a huge surprise to many homeowners.

"People who didn't have the money to meet their mortgage payments have found that they owe income taxes on tens of thousands of dollars," says Mark Luscombe, principal federal tax analyst with CCH, a tax software and publishing company in Riverwoods, Ill. "It seems like the tax system is kicking them when they're down."

Apparently, politicians thought so, too. Under the Mortgage Debt Forgiveness Act of 2007, some homeowners granted forgiveness of mortgage debt won't have to pay taxes on that amount. But there are some restrictions:

1. There is a limit on the forgiven debt: up to $2 million or $1 million for a married person filing a separate return.
2. The tax break also has a time limit. It only applies to mortgage debt discharged by a lender in 2007, 2008 or 2009.
3. The loan also must have been taken out to buy or build a primary residence, not a second or vacation home. If debt is forgiven on those additional properties, the owner will owe cancellation of debt income as usual.

Some significant tax law changes took effect Jan. 1. While they won't affect your 2007 return due this April, you might find them useful as you devise your 2008 tax strategies. They are:

1. Expansion of the home-sale exclusion for surviving spouses.

2. More changes to the kiddie tax.

3. Zero percent capital gains taxes for some investors.

Under prior tax law, a married couple could exclude up to $500,000 profit from taxation when they sold their home as long as they met certain conditions. After a spouse's death, the surviving spouse also could claim that exclusion amount if the home was sold in the year his other spouse passed away. In that situation, the widow or widower would be able to file a tax return using the married filing jointly status.

However, if the widow or widower sold the residence the next year or later, the sale exclusion was cut in half. Because many widows and widowers delay making such major decisions after losing a husband or wife, they were penalized by the tax code when they finally did sell their house.

But thanks to a provision in the Mortgage Debt Forgiveness Act, bereaved home sellers get some tax relief. Now a surviving spouse has two years in which to sell a home that was jointly owned and take the $500,000 gain exclusion.

"This is a significant new benefit, and the surviving spouse continues to be allowed a step up in basis in a jointly owned residence for the deceased spouse's one-half share. The $500,000 exclusion is in addition to that," says CCH's Luscombe.

Parents also need to pay attention to the Jan. 1 changes to the kiddie tax.

In order to save for their child's college costs, some parents open accounts in the child's name. Not only does this designate the fund for the youngster's use, but it also had the tax advantage of having the earnings taxed at the youth's usually lower rate.

However, when a child's account earns a certain amount ($1,700 in 2007, $1,800 in 2008), the kiddie tax kicks in. In essence, the kiddie tax requires that excess earnings be taxed at the parents' highest marginal tax rate (which could be as high as 35 percent) until the child reaches a certain age, at which time the child's lower rates (typically 10 percent to15 percent) then apply.

In 2007, a child's tax rates took effect when the youth turned 18. For 2008, the parents' higher rates will be collected on investment earnings until the child turns 19 or 24 if the youngster is a full-time student.

This change, says Luscombe, was designed to keep wealthier parents from taking advantage of another 2008 tax-law change, zero percent capital gains on lower-income investors.

Now about that new no taxes due law. Taxpayers in the 10 percent and 15 percent tax brackets can sell long-term assets this year through 2010 and not owe any capital gains on the profits. To qualify for the zero rate in 2008, a married couple must make less than $65,100 in taxable income; single filers earning less than $32,550 will pay no tax on their sales of assets they've owned for more than a year.

While the kiddie tax might keep many young investors from taking advantage of this law change, it could be a viable strategy for others such as retirees whose income will allow them to take advantage of the zero capital gains break.

Finally, in addition to the new 2007 tax code changes and prior year carryovers, many pre-existing laws have new dollar amounts this filing year, thanks to inflation adjustments. For details on these tax issues, see Bankrate's companion story, "Old tax laws, new amounts."

 SOURCE: BANKRATE.COM