The subprime mortgage problems we've all been reading about are getting larger. Last week I met with a young couple that may lose their home because they were caught in the complexities of a variable mortgage.

Their problem is that they have been making minimum monthly mortgage payments that were less than required to fully amortize the loan. This created a "negative amortized loan."

This means that with each minimum payment they made, about $1,000 per month was added to their original balance. Over 36 months, the original loan has climbed nearly $40,000.

With the softening of real estate prices, their home cannot be sold for the value of the mortgage. Now, their lender informs them that their loan will soon be reset to a fully amortized loan at 7.5 percent. Their payment will increase by more than $2,000 per month, a payment they cannot afford. Unless something miraculous happens, they are prime candidates for foreclosure.

This is a common dilemma today.

They may not know it, but the problem could become much worse for them. When they took out their mortgage, the lender gave them money, but they weren't taxed on it because of the mortgage obligation that was created at that time. If the lender forecloses and forgives any of the debt, this is considered "cancellation of debt" income.

This so-called "phantom income" would equal the difference between the loan balance and the fair-market value of the property at the time of the foreclosure.

Our couple originally borrowed $400,000 but now owe more than $440,000. If the property were appraised at foreclosure at $400,000, they would have $40,000 of "phantom income," which is taxed at ordinary income tax rates.

If they were in a 25 percent tax bracket, the "phantom income" could generate a $10,000 tax bill and it might also push them into a higher tax bracket when it is added to their normal taxable income.

This would be like adding salt to the already painful wound of losing their home.

Help may be on the way.

Last month President Bush called on Congress to temporarily make some borrowers exempt from this "cancellation of debt" provision.

Two bills have been introduced that President Bush likes, but the legislative process is slow. If either of the bills is passed, it may not help those who face this problem unless the new laws are retroactive.

Tax experts say there are ways around the problem, but each solution can cause other problems.

First, bankruptcy is an option. Debts discharged through bankruptcy are not considered debt cancellation. However, bankruptcy has a long-term effect.

Debtors may try to prove insolvency, but this can be difficult and credit damaging.

Also, if the mortgage was "non-recourse" debt, the loan may escape the debt-cancellation income problem.

For those facing foreclosure or other options, this is a good time to consult with competent tax advisors.

The IRS may work with taxpayers with big tax problems. They have the so-called "offers in compromise" to allow taxpayers to pay less than they owe.

Also, the agency may accept long-term payment plans plus interest.

The foreclosure-subprime mortgage problem may get much larger over the next year as hundreds of thousands of variable loans reset to current rates.

Each case is unique and I encourage any who would be affected by this problem to start working with their lender long before the loans reset.

Tom Mills is a Registered Investment Advisor and Certified Financial Planner. If you have questions or topics, you may call or write him at 1030 Seminary St. Suite D, Napa CA 94559, 254-0155, fax 254-0158 or e-mail suntrm@aol.com