Did you know that debt forgiven during a short sale or debt-forgiveness program is subject to tax (since the IRS considers the amount of the forgiven debt as income)? Most people don’t – and that could result in significant financial stress come tax time.

Under normal circumstances, the amount of debt forgiven by a lender on the behalf of a homeowner is taxed under standard income tax rates by the IRS. For example, if the owner of a $250,000 home still owes $125,000, is facing foreclosure, and wants to work with the lender to forgive the remainder of the $125,000 loan amount, he or she would have that disparity taxed. For most homeowners, that amount would be significant and could result in anywhere from 15% to 35%.

Of course, thanks to the Mortgage Forgiveness Debt Relief Act of 2007, homeowners in this situation can exempt up to $2 million on a principal residence (or $1 million for someone who is married but filing separately). For most Americans who are in this situation or have been since the housing market took a steep nose-dive in 2007, that is a welcome relief.

Unfortunately, the very same law that was such a boon for so many homeowners is set to expire at the end of this year. Much like other propositions and laws at the federal level, there is no guarantee that the law will be extended, even though there would be much pressure from constituents and consumer advocacy groups to continue the legislation. After all, the wildly-popular First-Time Homebuyer Credit was not renewed even though it arguably led to a spike in home sales that was desperately needed at the time of its inception in 2009.

Homeowners who are considering entering into a short sale transaction as a way to stop foreclosure need to be mindful of the tax considerations involved in the property transfer – especially those considering principal reductions with their mortgage loans. Since loan modifications take months on average to complete – and many fall by the wayside and fail during that timespan – homeowners caught unawares could be penalized heavily at tax time with an unexpected bill.

Also consider the fact that a deed in lieu of foreclosure – another common alternative to foreclosure in addition to a short sale- may also result in a taxable income situation if the law should expire. Homeowners should consult a certified tax attorney for qualified legal advice.