Mortgage Debt Relief Act Set to Expire

Homeowners confronting the challenges of foreclosure or the short sale of their homes may soon be facing yet another hardship — income tax on money they will never see.

For many years under U.S. law, people who were underwater on their mortgage, meaning they owed more than the property was worth, were taxed on the amount forgiven by the bank or credit union during a short sale. The difference between the debt owed and what was accepted as fair market value was considered income and therefore reported and taxable.

Nearly five years ago, in an effort to provide relief to people in over their heads with mortgage debt during a struggling housing market and tough economy, Congress passed the Mortgage Debt Relief Act of 2007. Under the act, homeowners have been able to exclude up to $2 million of debt forgiven on a principal residence ($1 million for a married person filing separate). This act, which benefited the millions of people in debt, is due to expire at the end of this year.

Financial Loss

Unless Congress intervenes, those homeowners already facing financial loss will be required to pay federal income tax on any portion of the debt forgiven during a short sale, foreclosure or restructure of a mortgage.

For example, if the relief act is not extended, beginning in 2013, a homeowner who settles a home with a $250,000 mortgage for $200,000 will be required to pay taxes on the $50,000 debt difference as if it were income, even though that money never actually exchanged hands.

Both legislators and real estate agents argue that the housing market has not recovered adequately enough to allow the act to expire. Bills have been introduced in both the House and Senate to extend the tax break another year or two, and the National Association of Realtors (NAR) has been lobbying Congress with the same goal.

The loss for homeowners already confronting financial difficulties could be devastating, say Realtors familiar with the short sale market. This could be distressing for those homeowners already facing large amounts of loss due to underwater mortgages. Depending on the tax bracket the homeowner falls under and the amount of debt forgiven, a person could owe anywhere from $10,000 to $100,000 in additional taxes.

Avoiding Foreclosure

Since foreclosures remain on a credit report for many years and significantly influence credit scores, short sales became very popular for people who owed considerably more than the property was worth. During a short sale, the lender agrees to release the homeowner from the mortgage for less than is owed and the property is sold to a third party. The process keeps homes out of foreclosure, and can save a lender 25 percent to 35 percent by eliminating multiple fees for inspections and attorneys.

According to the National Association of Realtors, as much as 14 percent of all monthly home sales activity since 2008 have been short sales — at least 1.6 million. Housing analysts anticipate, if the act is not renewed, that short sales will fall in the new year and many more homes will end up reaching foreclosure status.

Not only will this potentially harm the real estate market, but more homes could possibly sit empty and lose additional value.  Eventually, an influx of foreclosed homes will reduce the value of surrounding homes and negatively influence the overall sales market.