Lending institutions frequently offer struggling mortgage holders the opportunity to sell their home at an amount lower than the outstanding mortgage balance and write off the loss. That gap amount is actually income for the homeowner, and as such, is taxable. That means that if a homeowner with a mortgage of $120,000 short sells the home for $100,000, he must show $20,000 on his income tax return as income. This liability extends beyond short sales to include loan modifications in which the lender agrees to reduce the principle to an amount closer to the home value. Even the homeowner who loses his home to foreclosure is subject to this enormous tax burden. In the case of a foreclosure in which the balance of the mortgage is $100,000, the owner in a 25 percent tax bracket would find himself owing an additional $25,000 in taxes.
In 2007, Congress passed the Mortgage Forgiveness Debt Relief Act to exempt the reduced amount from tax liability. Congress extended the exemption twice in legislation over the next few years. Unfortunately, the exemption expired at the end of 2013, with over six million homes still underwater. In 2013, the exemption equated to $1.3 billion in total.
Lawmakers are arguing over three different bills calling for an extension of the tax exemption. All three do enjoy some bipartisan support. Unfortunately, there is no way of knowing what issues Congress will determine are the top priority as members debate the debt limits and government spending. The Making Home Affordable program, which offers relief to homeowners through short sales does not expire until December 31, 2015, however, the tax exemption is not a part of the program. When Congress allowed the government shutdown in October of 2013, members agreed to extend the debt limits until February 7, 2014. Extension of the Mortgage Forgiveness Debt Relief Act is a part of the new debate.
If the taxpayer can prove insolvency, meaning that he has more outstanding debt than assets, he may be able to avoid the burden of the additional tax related to the short sale or home loss. However, additional properties such as undeveloped land could easily negate that option. In short, the expiration of the Mortgage Forgiveness Debt Relief Act will not just affect the struggling homeowner; it could also have a serious impact on our struggling economy. Even a delayed decision will influence homeowners considering their options.