Given the huge public and private resources being devoted to helping financially distressed homeowners — including the recently announced $25 billion national mortgage settlement with five major banks — you might assume that a key federal tax-law benefit underpinning these efforts would be a shoo-in for renewal.
But it’s not. The Mortgage Forgiveness Debt Relief Act is set to expire in 10 months, and there are early indications on Capitol Hill that it might not make the cut. The law, first enacted in 2007, allows homeowners who have received principal reductions on their mortgages as the result of loan modifications, short sales or foreclosures to avoid income taxation on the amounts forgiven.
Loss of that tax help would endanger huge numbers of distressed mortgage arrangements in the months ahead. For example, the $25 billion mortgage settlement with state attorneys general requires the banks to provide more than $10 billion in principal reductions to borrowers. Meanwhile, other lenders and mortgage servicers that are not parties to the settlement already provide principal reductions to troubled borrowers. Many of these owners would face hefty and ill-timed taxable-income hits in the event the law is not extended.
Yet election-year politics and a contentious lame-duck congressional session loaded down with tax and budget issues could doom renewal of the debt-relief legislation and put large numbers of loan modification participants deeply in the hole. Republican strategists say the cost of continuing the program — $2.7 billion for two years — is substantial enough to catch the eyes of budget-deficit hawks. Beyond that, they add, some members of Congress may be opposed to what they see as still another targeted federal benefit for people who didn’t pay their mortgages — a benefit subsidized by taxpayers who did the right thing and stayed current on their loans even while underwater or facing severe financial distress.
Douglas Holtz-Eakin, president of the center-right American Action Forum, former director of the Congressional Budget Office and economic adviser to Sen. John McCain’s 2008 presidential campaign, said in an interview that there is “a powerful sentiment,” especially among conservative freshman House members supported by the tea party, that tax-code “bailouts” to delinquent and underwater homeowners are fundamentally unfair.
“It’s going to be an uphill fight” to get an extension through, he predicts.
Real estate and housing groups are worried about the same political dynamics and are gearing up campaigns to try to save the tax provisions in advance of the November elections and well before the expected year-end squeeze. Some industry lobbyists put the odds of getting a pre-election, stand-alone extension bill through Congress at less than 50-50.
Here’s what’s involved, and how it might affect someone who is contemplating a short sale or loan modification that involves debt forgiveness:
Prior to 2007, all cancellations of debt by creditors — whether on auto loans, personal loans or mortgages — were treated as taxable events under the federal tax code. If you owed $200,000 but paid off only $150,000 through an agreement with the lender, the $50,000 difference would be ordinary income, taxable at regular rates.
Under the debt relief law for qualified homeowners, married couples filing jointly can avoid taxation on forgiven mortgage amounts up to $2 million; the limit is $1 million for single filers. To be eligible, the debt must be canceled by a lender in connection with a mortgage restructuring, short sale, deed-in-lieu-of-foreclosure or foreclosure. The transaction must be completed no later than Dec. 31.
That impending deadline — and the risk that Congress won’t reauthorize the law in time — already has real estate professionals and tax planners on edge. “This is serious,” said Harrison K. Long of Coldwell Banker Residential Brokerage in Irvine, Calif. “Anybody thinking about doing a short sale this year needs to get moving on it now,” given the long timelines needed to complete such transactions — often from four to 12 months.
Picture this scenario: You negotiate for months with your lender, realty agents and potential buyers. Finally you pull together a short-sale package calling for the bank to forgive $100,000. But the deal runs into hitches and doesn’t go to closing until after the Dec. 31 expiration date. Now your house is gone, your credit is shot, you’re looking for a place to rent and the IRS demands taxes on your phantom “gain” of $100,000 on the sale.
With that sort of nightmarish liability on the line, it’s worth it to gear up for action sooner, not later.
Ken Harney’s e-mail address is firstname.lastname@example.org.