We paid the minimum monthly payment required, which didn’t cover all the interest owed, so that amount was added to our mortgage balance. Like others, we have experienced the nightmare of the current housing market, and with the negative amortization adding on even more debt, we are severely underwater.

We’ve worked with two companies trying to get a workable loan modification but to no avail. The bank is not cooperating at all.

A lawyer I consulted is advising us not to pay at all going forward, saying that the upside-down home isn’t worth saving or worth the grief. She told us to put our payment amounts into savings so that we have something to live on after we have to leave the home, which I so far have been able to do. But I’m worried about the potential fallout.

Would we be required to pay taxes on the remaining balance we owe after a foreclosure? If we can’t afford to pay the taxes on $200,000 of untaxed income (that we really didn’t earn), what do we do then? Does bankruptcy help with that?

Answer: When a lender cancels or “forgives” debt, it typically sends you a Form 1099 for the amount of forgiven debt. This amount usually must be included as income on your tax return. But there’s a big exception when it comes to mortgage debt secured by your primary residence.

The Mortgage Forgiveness Debt Relief Act of 2007 generally allows you to exclude from your income the debt that’s left over after a foreclosure. The law applies for the calendar years 2007 through 2012.

You can find more information about the act in IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments, as well as in IRS news release IR-2008-17.

In some cases, lenders aren’t content to write off the excess debt and instead decide to pursue homeowners after foreclosure for the remaining balance owed. You may be protected by state law from such a lawsuit (as homeowners in California typically are), but you’ll want to discuss this possibility with your attorney. If you are hit with such a lawsuit, you may need to consider filing for bankruptcy.

Given that I don’t get a refund on April 15 and end up having to pony up a lot of money, is there a way for me to set aside my self-employment income into a retirement account such that I can just bypass all taxes on it, including payroll taxes? Would a traditional IRA work that way? If so, how would the IRS know that I’m putting money aside from my self-employment income and not from my regular day-job income?

Answer: To answer your last question first, the IRS doesn’t really care where the money comes from when you pay your tax bill. It mostly just cares about getting paid.

That said, you probably won’t be able to avoid self-employment taxes on your side business income, although you should be able to reduce or even eliminate owing income taxes on the money, said Eva Rosenberg, an enrolled agent who writes about taxes at TaxMama.com. (Self-employment taxes are your contributions to Social Security and Medicare.)

“The only way to reduce self-employment taxes is to reduce self-employment income,” Rosenberg said. “Putting money into retirement plans of any kind will only reduce income taxes.”

One way to reduce your self-employment income is to incorporate and then have your corporation contribute to your retirement plan directly, “thus wiping out most of your wages,” Rosenberg said. “However, the cost of incorporating and the annual filing and fees related to all that will certainly exceed your self-employment taxes on $7,000.”

What might make more sense if you want to reduce your income taxes is to contribute the maximum $5,000 to a traditional IRA, which offers a tax deduction for contributions, instead of funding a Roth, which does not. Even though you have a retirement plan at work, you can deduct your full contribution if your modified adjusted gross income is under $56,000.

Another option is a solo 401(k), which would allow you to put aside up to 100% of your compensation (although again, you would still owe self-employment taxes on that compensation).

Also, if you expect to owe more than $1,000 at tax time, you should be making quarterly estimated tax payments instead of waiting until April 15 to pay your tax bill.

Answer: In both instances, sensitive financial documents were entrusted to the U.S. mail system. Although this is common, it’s certainly not secure, since such mailings aren’t tracked and they certainly aren’t encrypted. The two taxpayers didn’t think to question the way their papers had been handled until those papers went missing, but both taxpayers and tax preparers would be wise to use more secure methods to transmit sensitive data.

Answer: Actually, the reader followed up to say her supporting paperwork eventually made its way to her mailbox. The return itself, as noted in the column, was electronically filed without her permission or review.

Whether there’s a software glitch or simply overworked preparers making mistakes is unclear. But these experiences do highlight the risks of using the U.S. mail for sensitive information. Here are another reader’s thoughts on the subject:

Dear Liz: As a tax preparer, I deal with clients who live 100 or more miles away, and I have never had a problem with mailing of documents in either direction. Perhaps they may be delayed somewhat, but they have always arrived. As to the issue of the preparer filing electronically without permission, the IRS mandates that a return can be filed electronically only after the preparer receives the taxpayers’ approval (IRS Form 8879 must be signed by the client). Therefore it appears that the tax preparer in this case may have acted in a manner not acceptable by taxing agencies. This is something taxpayers should be wary of in dealing with tax preparers.

Answer: That’s definitely true, but perhaps you should consider being a little more wary of the mail system. Just because nothing has happened yet to all that sensitive data doesn’t mean something can’t or won’t. It may cost a little more, but if your clients can’t drop off information and pick it up themselves, paying for delivery services that offer tracking information is a way to make these transactions more secure.

I typed in $3,477.22, which is the federal tax burden for a family of four exactly in the middle of the income spectrum (with a household income of $75,594). Here’s where their tax dollars go:

• Social Security: $711.09
• Defense: $701.43
• Medicare: $454.39
• Low-income assistance: $322.86
• Medicaid: $274.44
• Net interest payments: $229.90
• Unemployment compensation: $163.14

Way down at the end of the list are some other expenditures of note, incuding $19.69 for foreign aid; $5.87 for Congress; and $2.55 for arts and culture.

This could give you some ammunition when your windbag uncle insists that the reason we’re broke is because of foreign aid, or when your annoying sister-in-law tries to insist that the deficit, and the interest payments we make on it, are no big deal.

Go ahead–get your receipt for taxes paid. It’s illuminating.

Spend what’s left in your flexible spending account. FSAs are workplace plans that allow you to save pretax money to cover medical expenses not paid for by your insurance, and many require that you incur eligible expenses by midnight Dec. 31. Furthermore, starting Jan. 1, you will no longer be able to use your FSA money for over-the-counter drugs without a doctor’s note. So today’s the day to stock up on aspirin, decongestants, first aid kits and other soon-to-be-ineligible expenses (for Aetna’s list per the IRS, click HERE).

Make those last charitable contributions. If you itemize your deductions, you can get a tax break for giving to legitimate charities by midnight. You can charge the donation today with a credit card; as always, just make sure you can pay the bill in full when it arrives. Check out the charity at Charity Navigator or similar sites. Bankrate has this article on getting the most of your charitable deductions.

Boost your retirement contribution. If you pay Social Security taxes, you’ll be getting a one-year, 2% tax cut starting Jan. 1. Consider using that break to boost your 401(k) or 403(b) contibutions. If you’re at work today, you can arrange that with your human resources department. Otherwise, make a note on your calendar to do so as soon as you return to work.

Today’s Wall Street Journal has an article about how this Congressional inaction is giving the Treasury Department fits, since normally by now the Treasury would be preparing withholding tables for employers–and nobody knows what the right withholding will be.

But the real story is contained in the graphic that accompanies the article, which shows how much your income taxes are likely to go up if Congress fails to act and the tax breaks expire:

• A household making $40,000 would see its paychecks shrink by $95 a month if it had no children, $135 if it had one child and $165 if it had two children.
• A household making $80,000 would see its monthly paychecks shrink by $145 with no kids, $150 with one and $180 with two.
• A household making $100,000 would clear $270 less per month with no kids, $300 less with one and $335 less with two.

I can’t imagine that anyone in today’s economic climate would be happy to see his or her paycheck shrink by that much.

You might want to let your lawmakers know how you feel. You can find your congressional representative here and your senators here.

Janice Chaffin, head of Symantec’s Norton Business Unit, offers these tax season safety tips:

1. Carefully select your tax prep provider or software.
Visit the IRS Web site for approved software partners that support online filing. If you use a tax prep provider, don’t just go with someone who promises big refunds. Ask if friends have used him/her before.

2. When ready to eFile, make sure your Internet connection is safe.
When you are using an online tax prep service, look for indications that the connection is encrypted (you should see the address change to “https” and a lock symbol appear in the browser frame). Don’t prepare or file taxes on a shared, insecure connection like the open Wi-Fi network in your neighborhood coffee shop.

3. Turn off (or remove) any peer-to-peer file sharing services.
If you use peer-to-peer services (like LimeWire, Kazaa, BitTorrent), you can inadvertently allow a criminal anywhere in the world to find your tax file record (usually a pdf file) on your computer, revealing all your personal information. It is best not to use these services, during tax season or any other time of the year.

4. Encrypt and secure any pdf copies of the return on your computer
In your My Documents view, right-click a file name to select “Encrypt.” Print out a copy and put in a safe location in your home. Back up or store additional copies to save someplace else.

5. Make sure your Internet security software is on and up-to-date.
Symantec advises all computer users to keep their security software updated; keep their computer systems clean and continue to use general best practices for staying safe online. Find more information on how to prevent criminals from invading your computer here.

Answer: It’s too late for you, but others who may be tempted to ignore their obligation to file tax returns need to know two things.

The first is that the failure-to-file penalty is much worse than the failure-to-pay penalty. Since the IRS offers payment plans, it’s better to file than not, even if you can’t pay right away.

The second is that you have only three years to file a tax return before you lose any refunds to which you might have been entitled.

In short, not filing can cost you, big time. You don’t need to throw yourself on the IRS’ mercy, but you should find a good tax preparer who has dealt with this issue before. Many have, as there seems to be no shortage of people like you. Your local certified public accountant society or the National Assn. of Enrolled Agents, at www.naea.org, can provide referrals.

Oh, yay.

Not only are taxes a pain to confront, but they’re easy to get wrong. Here are five big mistakes to avoid:

Failing to file. Every year, I hear from people who have hidden under a rock for years–years–when tax season rolls around. They want to come clean, but are afraid the IRS will send storm troopers to carry them away. Relax: simple failure-to-file isn’t a crime, although it can be costly. Failure to file penalties are much worse than failure to pay penalties, and you lose out on any tax refunds you might have gotten after three years have passed. The fix is straightforward: find yourself a CPA or other good tax pro, bring what documentation you have and take your medicine.

Doing complicated taxes themselves. I’ve used a tax pro ever since starting my first freelance business many years ago, and that was even in the years when I was doing our taxes eight or nine times a year to test out various tax software. My pro has always found deductions I missed and been a great resource year-round. If you’ve got a business or a lot of investments, find yourself an expert. At the very least, you should be using software like Turbotax–today’s tax code is simply too complex to tackle by hand.

Paying with a credit card. Whatever rewards you’re getting from using a card are more than offset by the fees charged to use plastic. If you can’t pay right away and have a very low rate on your card, charging could make sense, but the IRS’ payment plans also come with pretty low interest rates.

Using rewards points to pay your taxes. American Express just announced that you can do this with their rewards cards, but the exchange rate is awful. You need 200 points to pay $1 in taxes, according to CreditBloggers.com. (Normally, you want an exchange rate of at least 1 cent per point or mile; CreditBloggers points out you can get a $25 Barnes and Noble card on Amex’ site for 2500 points, and even the less desirable exchange rates that typically apply for merchandise typically give you 100 or so points to the dollar.)

Taking out a refund anticipation loan. If you file electronically and opt for direct deposit, you can get your refund in about 10 days. That’s all. It’s insane to pay an interest rate that’s effectively in the triple digits to get your money faster from a tax preparer that offers refund anticipation loans. If you need the money so badly, then file earlier in the season; your wait time may be even shorter.