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Is that your primary residence?
When the debt is forgiven and it becomes obvious that it will not be paid back - that amount is classified as COD - cancellation of debt (COD) income - and it is income recognized because loans are cancelled.
In general, you must report any taxable amount of a canceled debt for which you are liable as ordinary income from the cancellation of debt, on Form 1040 line 21.
under certain conditions - you might be able to exclude COD income from taxable income.
Specifically if the loan is related to your primary residence - you are eligible to claim an exclusion.
That exclusion is claimed on form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness and that form 982 should be included into her tax return.
Here is the form -
Let me know if you need any help with reporting.
Please be aware that while the Mortgage Debt Relief Act which allows the exclusion was extended through 2016.It is NOT extended by California income tax purposes.So - because you are in California - you might want to use a different exclusion - which is based on insolvency.