The Washington Post

Some homeowners could get hit with a whopping tax bill if they accept help through Bank of America’s settlement 

Attorney General Eric Holder announced Thursday that the Justice Department had reached a $16.65 billion settlement with Bank of America for financial fraud leading up to and during the financial crisis, the largest civil settlement with a single entity in American history. (Alex Wong/Getty Images)

The $17 billion settlement that Bank of America reached with the Department of Justice on Thursday provides mortgage debt relief for some troubled homeowners. But those that accept the help could get hit with a hefty tax bill later.

As part of the settlement, the bank agreed to provide $7 billion on helping struggling homeowners and communities, including lowering the mortgage balances of certain borrowers who owe more than their homes are worth. The problem is that some of these "underwater" borrowers might have to pay taxes on the debt that’s forgiven.

In 2007, Congress adopted a law that spared homeowners from being taxed on the amount of the loan that was written off.  But that tax break expired in December, and now that kind of relief can be counted as income by the IRS, an issue we wrote about in April.

(Read More: Distressed homeowners seeking mortgage relief could get stuck with higher taxes)

In negotiating the deal, the Justice Department recognized that many of the borrowers it was trying to reach would be in no position to accept the help if doing so would lead to a huge tax bill.

"That’s why the Department secured a commitment from Bank of America to pay a portion of the settlement – over $490 million – to defray some of this tax liability," U.S. Attorney General Eric H. Holder Jr. said when he announced the deal. "And our settlement requires the bank to notify all consumers of the potential tax liability."

Holder went on to warn that unless Congress acts, "the hundreds of thousands of consumers we have sought to help through our settlements with JPMorgan Chase, Citigroup, and now Bank of America, may see a significant tax bill just as they are beginning to see the light at the end of a dark financial tunnel."

The Bank of America settlement includes a program that would reduce the size of the borrower’s mortgage so that the loan accounts for 75 percent of the value of the home, and the interest rate would be permanently set at 2 percent.  Such "principal reductions" are considered one of the most effective ways to help underwater borrowers who owe more than their homes are worth.

(Read: Bank of America and DOJ reach $17 billion settlement over mortgage securities)

Associate Attorney General Tony West offered an example of how that would work for a homeowner who owes $250,000 on a house that’s worth only $150,000. Under the plan, the balance of the mortgage would be reduced to about $112,000. But the roughly $137,000 forgiven could be a tax liability.

To help pay such liabilities, the settlement has a 25/25 Tax Relief Fund. Once the mortgage debt is forgiven, 25 percent of the value of that relief will be made available to help offset any tax liability for the borrower, up to $25,000, West said.

"Now, this will help tens of thousands of consumers to offset, at least in part, any taxes that result from consumer relief they receive as a result of this settlement," West said. "But it's only a temporary fix; the fund isn't large enough to cover every potentially affected consumer, which is why the best solution to this problem is for Congress to heed the attorney general's call to extend the tax relief coverage."

Congress has renewed the tax break – also known as of the Mortgage Forgiveness Debt Relief Act -- twice since enacting it in 2007. Yet despite the tax break’s broad popularity, it is unclear whether Congress will renew it again. The Senate Finance Committee voted to revive the break for the 2014 and 2015 tax years. But the provision is part of a larger package of expired breaks that is ensnared in a partisan dispute over comprehensive tax reform, and it could be derailed on the Senate floor or in the Republican-controlled House.

Congress plans to settle the matter after the midterm elections in November.

An analysis by the Urban Institute found that about 2 million homeowners will be at risk of incurring that kind of tax liability, and a congressional analysis estimates that borrowers will be on the hook for $5.4 billion in extra taxes if Congress fails to renew the tax break.

Dina ElBoghdady covers housing policy for The Washington Post.

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