A proposed bipartisan bill aimed at amending the tax code so that debt forgiveness relating to principal home mortgages is no longer treated as income will soon be working its way through the U.S. Congress.

Currently, homeowners who are substantially delinquent on their mortgages face harsh IRS consequences: If their lender accepts to modify their home loan and forgive any portion of their debt, a federal income tax is imposed on the sum that is forgiven. More specifically, when a creditor wipes out personal liabilities, the IRS treats the amount forgiven as income, except if the taxpayer is bankrupt or insolvent. Furthermore, the law requires the creditor to report the sum canceled to the IRS.

The status quo is burdensome for the increasing number of subprime borrowers with bad credit whose position in the present real estate market is not an enviable one: Due to a convergence of factors such as plummeting property values, zero down payments, and significant payment increases that they cannot satisfy, homeowners find themselves with a mortgage debt exceeding the value of their home.

The proposed Congressional legislation could provide much-needed relief for financially-strapped homeowners. The Mortgage Cancellation Tax Relief Act of 2007 (HR 1876) would reform the tax code so that debt forgiveness concerning principal home mortgages is no longer considered income.

The bill, sponsored by Reps. Ron Lewis (R-Ky) and Robert E. Andrews (D-N.J.), would permit creditors to rearrange delinquent mortgages without the prospect of an income-tax punishment looming over their clients’ heads the following year. HR 1876, which was introduced in mid-April, might also be a saving grace for many other borrowers in financial distress who are engaged in pre-foreclosure ”short sales” (deeds-in-lieu-of-foreclosure) negotiations or who have inadequate foreclosure proceeds to cover their mortgage debt.

Short sales are on the rise and becoming increasingly prevalent. Let us take an example: A homeowner is seriously delinquent on his mortgage payments and is informed that a rate reduction or a restructuring of his loan will not take him out of the red since he is now jobless. Instead of resorting to foreclosure, the homeowner’s lender might advise him to quickly sell his home, most likely to an investor who will purchase the property as-is at a reduced price. If the short sale yields $10,000 less than what the debtor owes on the mortgage, and the creditor accepts to forgive that sum; the Andrews-Lewis legislation would allow him to obtain the debt forgiveness tax-free.

Supporters of the debt-relief reform proposal explain that mortgage delinquencies, foreclosures, and short sales are extremely taxing situations for the majority of borrowers. They argue that no public policy objective is served by imposing tax penalties that aggravate matters for already-struggling homeowners.

HR 1876 is presently before the House Ways and Means Committee, Congress’ most important tax legislating organization. In view of the fact that most of the Democratic banking and housing committee heads have urged mortgage companies and banks to meet homeowners halfway to avoid foreclosure, it is reasonable to expect that Congress will pass this tax fairness legislation.