An important law which has eased the financial fall-out from the mortgage crisis has ended. The Mortgage Forgiveness Tax Relief Act expired on New Year's Eve and unless the legislation is extended large numbers of troubled borrowers will suddenly face huge new taxes.
In 2007, when the mortgage meltdown was plainly underway, the government enacted the Mortgage Forgiveness Debt Relief Act. This was a law designed to stop a very strange tax, a tax on income people never received, so-called “imputed” income.
To see how the tax worked, imagine that you bought a home with a $175,000 mortgage. After job losses, medical bills or other calamities you can no longer afford the home. The property is then sold with a short sale or foreclosed and in the end the lender is only repaid $125,000 from the sale or auction.
This means $50,000 in canceled debt is unpaid — “imputed” income you never received but cash the IRS regarded as taxable money.
In 2007, Congress changed the rules. As much as $2 million in forgiven homeowner mortgage debt could be non-taxable, $1 million if married filing separately — at least until the end of 2013.
Foreclosures and Short Sales
One of the big reasons to have a short sale or a deed in lieu of foreclosure is that there are real benefits to borrowers. The loss of a home is an awful event, but it's worse if it comes with a huge bill from the IRS for unpaid taxes for phantom income, money never received.
Once the Mortgage Forgiveness Debt Relief Act expires, said Senator Barbara Boxer (D-CA), “distressed borrowers may face the unfortunate incentive to go to foreclosure rather than seek a short sale in order to avoid a large tax bill.”
Without tax forgiveness foreclosure levels might begin to rise significantly because fewer borrowers will be inclined to engage in a short sale. Especially in judicial foreclosure states, borrowers might be able to stay in their homes for months if not years as their cases wind through the legal system. Lender losses would grow substantially in such situations, but tax collections would see little increase. Why? Because more borrowers would simply declare bankruptcy, another way to avoid the tax on unpaid mortgage debt.
This is not a small matter. In California, for example, it has been estimated by the California Association of Realtors that 2014 would bring 55,000 short sales with an average lender loss of $60,000 per property. If such transactions become foreclosures rather than short sales the result could be more discounts showing up on comps, thus lowering sale values for all nearby properties.
"It is bad enough that so many families are faced with mortgages that now exceed the value of their home," said Senator Debbie Stabenow (D-MI). Stabenow is the co-author of legislation to extend the relief provision along with Sen. Dean Heller (R-NV).
Stabenow added that "without this bipartisan bill, the IRS would once again require these families to pay hundreds or thousands of dollars in additional income tax when they sell or refinance their home. That's just wrong."
If the deadline is not extended, said the National Association of Attorneys General, "financially strapped homeowners, even those who lose their home to foreclosure, will be forced to pay taxes as income on any mortgage debt that is forgiven by the holder of the mortgage."
Debt Forgiveness Extension
Although extended several times, and although legislation exists to continue the deduction for through 2015, at this writing mortgage debt relief at the federal level is over and done beginning with the start of the New Year. It could be extended retroactively in 2014, but no one can say with certainty that such legislation will pass the Congress.
Alternatively, borrowers may find some help at the state level. Maryland, for example, has passed legislation to protect borrowers with unpaid mortgage debt, but the legislation applies only to state taxes.
If you find you have unpaid mortgage debt beginning in 2014 please check with the IRS and a tax professional for the latest information. It's possible that mortgage debt relief will be continued, not the first time Congress has acted at the last moment or retroactively.
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