Deed in lieu of foreclosure cancels the debt you owe, in exchange for the deed to your house.

So when a debt is canceled, income tax is often due on this "cancellation of debt" income. Some people call it "phantom income."

The IRS has this to say about the matter:

• Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you.You are insolvent when your total debts are more than the fair market value of your total assets.Insolvency can be fairly complex to determine and the assistance of a tax professional is recommended if you believe you qualify for this exception.
• Non-recourse loans:A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral.That is, the lender cannot pursue you personally in case of default.Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income.However, it may result in other tax consequences, as discussed in Question 3 below.

In plain English, most of us have a significant amount of our net worth tied up in our house. If our house is under water, that is, if we owe a lot more on our house than it's worth, then chances are we are technically insolvent according to the IRS. And so if we lose our house in foreclosure or in deed in lieu of foreclosure, we do not have to concern ourselves with a tax bill from the IRS.

Finally, on December 20, 2007, President Bush signed a law that exempts foreclosures from "cancellation of debt" income so long as the house is your principal residence, and the amount of the cancellation of debt is under $2 million. So that clarifies things if you are NOT technically insolvent and the house you have done the deed in lieu on is your principle residence.