For real estate investors looking for pre-foreclosure bargains, a new federal law could unleash a torrent of short sales as struggling borrowers facing foreclosure unload their over-mortgaged homes to avoid huge tax bills on capital gains.

HR 3648, or the Mortgage Forgiveness Debt Relief Act, signed by President George W. Bush on Dec. 20, helps people whose homes are in foreclosure by canceling taxes on any mortgage debt that has been forgiven by their lender. The government previously viewed the difference between the debt and the value of the home as taxable “income.” Now it does not.

The tax change, says investor and author Thomas J. Lucier, means more struggling borrowers will consider selling their homes to investors through short sales. A short sale is a pre-foreclosure sale in which the mortgage lender agrees to accept less than what they are owed on the property.

“It’s going to change everything,” said Lucier, a Tampa, Fla., investor and author of the Pre-Foreclosure Property Investor’s Kit. “Since most people in foreclosure today have zero equity in their homes, more homeowners will be willing to strike a deal with investors.”

Lucier said that with no “phantom income” tax looming in their future, struggling homeowners may be more willing to pursue a short sale for their home rather than await foreclosure. Investors could potentially use this information to their advantage when negotiating with sellers in order to pursue a short sale with the bank and ultimately purchase the property for a lower price.

The primary intent of HR 3648 is to assist homeowners who are facing foreclosure. When a homeowner opts for a short sale, they are often “forgiven” the difference between the sale price of the property and the balance on their mortgage, known as the deficiency. In the past, the lender reported the forgiven deficiency as 1099 income that was taxed, adding a greater financial burden onto an already struggling taxpayer. HR 3648 excludes this phantom income from the sellers’ gross income, exempting them from taxation of their forgiven debts on principal residences.

If a person, for example, owes $200,000 on a mortgage, and the borrower and the bank agree to sell the house for $150,000, the $50,000 debt forgiven by the lender will not be taxed. For the next three years, the IRS won’t count as income debt forgiven by lenders when troubled borrowers negotiate short sales or work-outs on their primary residence that involve forgiveness of part of their debt.

“We are entering uncharted waters,” claims Lucier, a 25-year veteran real estate investor and pre-foreclosure expert. “I’ve never seen the real estate market so bad.”