Mortgage Forgiveness Debt Relief Act Nearing End Date

By Monday of next week, unless something drastic happens fast in Congress, the United States will drop off the so-called fiscal cliff. About $600 billion in simultaneous tax hikes and spending cuts will take effect in January 1. Aggravating matters for the many homeowners who are still underwater, the Mortgage Forgiveness Debt Relief Act will also expire come December 31.

The Mortgage Forgiveness Debt Relief Act, which was introduced in Congress on September 25, 2007, and became law on December 20, 2007, temporarily suspends the enforcement of the federal tax code by granting relief to homeowners who would otherwise owe taxes on forgiven mortgage debt after facing foreclosure. The act originally provides such tax relief for three years, applying to debts discharged in 2007 through 2009, but this was extended for another three years to cover debts discharged until the end of 2012 through the Emergency Economic Stabilization Act of 2008. The tax exemption applies only to debt related to a primary home. Mortgages on vacation and rental properties are not exempt under the act. From the point of view of the Internal Revenue Service, housing debt that is forgiven or written off is the same as earned income. If the law expires, forgiven mortgage debt will be taxable as if it were earned income. The same view is applied to foreclosures and to loan modifications so long as the principal is reduced.

Most economists credit the beginning of the recovery of the housing market to the surge of short sales that have taken place this year. They say that short sales represent win-win scenarios for all parties affected by default -  the lending institution takes a smaller loss and does not have to assume the property on its books; the home seller avoids the financial burden of an underwater home without decimating his credit; and the neighborhood fares better than it would with another foreclosure since the property does not become vacant and its sale price would not affect the values of nearby homes as much as a foreclosure sale would.

Once the Mortgage Forgiveness Debt Relief Act expires, the incentive to pursue short sales would be lost. Imposing a federal income tax on that forgiven principal amount would discourage underwater homeowners from considering the short sale process and in fact even push them to just walk away from their distressed properties entirely. Daren Blomquist, vice president of real estate data firm RealtyTrac, in a recent statement, warned, “The prospect of being taxed on potentially tens or hundreds of thousands of dollars in additional income may motivate more distressed homeowners to forgo a short sale and allow the home to be foreclosed. Additionally, if the mortgage interest deduction is eliminated due to the fiscal cliff quagmire, it would give many underwater and otherwise distressed homeowners one less reason to hang on to their homes.”

Recently, forty-one state attorneys general have appealed to the House and Senate to pass an extension so as not to disrupt the $25-billion nationwide "robo-signing" settlement they negotiated with five major lending institutions. Among other provisions, the settlement encourages the five major banks to forgive billions of dollars in mortgage debt next year and beyond. Based on Congressional estimates, a one-year extension of the Mortgage Forgiveness Debt Relief Act would only cost the federal government $1.3 billion in foregone tax revenues over the next ten years. Nationwide, according to mortgage industry estimates, about 11 million home owners are still underwater.