New rules published by the Internal Revenue Service could save huge amounts of money for millions of financially troubled homeowners, especially those who sell for less than their bank is owed.

Q: We purchased our home in 2005, before prices in our area started dropping, but had to sell it last year after my husband lost his job and the interest rate on our adjustable-rate mortgage almost doubled. The bank agreed to a “short sale,” which allowed us to avoid foreclosure and eliminate our entire loan balance even though the proceeds of our sale totaled about $30,000 less than we owed to the bank. A few months ago, you wrote that Congress wanted to reduce taxes on people who found themselves in a situation like ours. Did the tax changes get approved? If so, could you provide details about how they work?

A: Sure. The legislation, officially called the “Mortgage Forgiveness Debt Relief Act of 2007,” was signed into law by President Bush in late December as part of the government’s efforts to ease the pain that sellers and other property-owners are feeling in the wake of the housing market’s downturn and ongoing problems in the lending industry.

Several other readers have been asking about the Debt Relief Act, sometimes called the “DRA.” The IRS only recently hashed-out details and printed revised forms for taxpayers to claim the law’s new breaks, so I’m devoting this entire column to answering some of the most common questions.

A key portion of the tax revisions involve so-called debt-cancellation income. Before last year, if the bank agreed to cancel your debt even if your home was sold for less than the amount owed, you’d have to pay income taxes to the IRS on the amount of debt that was forgiven. Ditto for borrowers whose lenders provided debt relief to refinance a loan instead of seeing the property fall into foreclosure.

To illustrate, let’s say that you purchased a home in 2004 for $200,000 but financial difficulties forced you to sell in 2006 for only $170,000 because property values in your neighborhood had declined. Even if the bank had agreed to wipe out your extra $30,000 in debt, the feds would levy a tax on the $30,000 difference – just as if you had earned an extra $30,000 from your job. For taxpayers in the 28 percent tax bracket, that would mean an additional $8,400 owed to the IRS.

Q: How does the new law change this?

A: The DRA completely eliminates taxes on mortgage debt-cancellation for the majority of people who sold their home for less than its loan balance in 2007. The same rules will apply in 2008 and 2009.

The change could literally save millions of people thousands in tax dollars each, considering that an estimated 9 million homeowners currently owe more than their property is worth.

Q: How do I claim this tax break?

A: You must fill out IRS Form 982, “Reduction of Tax Attributes Due to Discharge of Indebtedness,” and include it as part of your upcoming return. Despite its formidable title, the form can actually be completed in just a few minutes.

The document also must be accompanied by a 1099-C form, which the bank provides to verify the amount of debt that it forgave.

Q: Is there a limit on how much I can earn and still be eligible to avoid the tax on debt-forgiveness?

A: There’s no limitation on earnings, but there is a limit on the amount of the mortgage: The new breaks apply only to married joint tax-filers who get debt relief if the balance of their home loan was less than $2 million, or single tax-filers whose balance was less than $1 million.

Q: Where can I get more information about these tax changes?

A: Start by getting your free copy of Form 982 and its instructions by calling the IRS at (800) 829-1040, or by downloading the information from www.irs.gov. After you have familiarized yourself with the rules, consult a tax expert to see how they apply to your personal financial situation.