Tax relief may expire for underwater homeowners

People walk past a mortgage advertising stand.

Fernando Herboso says short sales have declined, but people still need help.

Many people have regained equity in their homes lately, thanks to rising housing prices. But for others, the housing crisis isn’t over. Almost 15% of mortgaged homes are still underwater, to the tune of more than $400 billion, according to CoreLogic’s second quarter figures.

Now struggling homeowners who seek relief could face an unexpected tax bill.

Real estate broker Fernando Herboso thinks it’s unfair that a law called the Mortgage Forgiveness Debt Relief Act expires this month. He remembers how hard it was for underwater borrowers before the law passed. As the market declined, they started calling him, saying:

“Fernando, I’m having problems paying. I don’t know what to do.”

Soon, he was helping his clients with short sales in Maryland, Washington DC, and Virginia.

Let’s say a client owed $300,000 on her home, but could only sell it for $200,000.

Herboso would explain that in a short sale, “The bank then gives you an imaginary check for the other $100,000.”

In other words, the lender forgives that mortgage debt. But there’s a catch.

“Then the IRS sees that as an income,” Herboso would explain. “Someone just gave you a check for $100,000. And you have to pay taxes for it.”

In normal times, mortgage debt that’s forgiven through short sale, mortgage restructuring, or even foreclosure can be considered taxable income. But in late 2007, Congress recognized that people on the brink of losing their homes couldn’t pay a hefty tax. So it passed the temporary law exempting from taxation a lot of canceled mortgage debt on primary homes.

“Early on, when this was passed, you could argue it simply wasn’t a matter for individual households, it was a macroeconomic matter,” says Mark Calabria, who was senior staff at the Senate Committee on Banking, Housing and Urban Affairs when the act first passed.

“We’re at the point now where it’s not really a macroeconomic matter,” he says.

Calabria is now at the Cato Institute. He says that since the worst of the housing crisis is over, he’d lean towards letting let the law expire. He says we shouldn’t create the wrong incentives.

“If you’re underwriting somebody’s losses on the housing market, then you’re much more encouraging people to take risk in the housing market,” he says.  

But David Stevens, president and CEO of the Mortgage Bankers Association, says parts of the country are still struggling.

“And the problem with this is this will now create, potentially, an impediment for a borrower who could be offered a debt forgiveness program,” he says.

They’d get debt relief on one hand, and a tax bill in the other.

Recent settlements with banks like JP Morgan Chase make more funds available to forgive mortgage debt. The question for Congress is whether taxing that help will force people to forgo it.

For those of you interested in the nuts and bolts of mortgage debt forgiveness, here’s more information:

-          The Mortgage Forgiveness Debt Relief Act of 2007 has been extended twice already.

-          If the measure expires on December 31, Congress could extend it retroactively.

-          The IRS on mortgage debt forgiveness, including caps and exemptions for insolvency.

-          Why Californians may avoid these taxes, even if the law expires. H/t to the Wall Street Journal.

About the author

Kate Davidson is a regular contributor to Marketplace.

Fernando Herboso says short sales have declined, but people still need help.

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