WASHINGTON — Beginning on Jan. 1, people who lose their home to foreclosure will be required to pay federal taxes on any unpaid mortgage the bank can’t recoup through an auction. The same will be true for homeowners whose loan principal is reduced by a mortgage modification, with the wiped-out loan being treated as taxable income.
The new tax obligation will hit because the Mortgage Forgiveness Debt Relief Act expires at the end of the year. The 2007 law was passed to save struggling homeowners from getting whacked twice, first by the sagging housing market and second by the Internal Revenue Service. Its expiration could push more people to remain in homes worth less than their mortgages, slowing the housing market’s recovery.
“The housing market is in its first stages of recovery, making now the worst time to take this exemption away from homeowners,” Rep. Jim McDermott (D-Wash.) told HuffPost. McDermott has introduced one of the bills geared toward extending the exemption.
“This exemption allows homeowners to write down their mortgages and refinance without incurring a hefty tax bill,” he added. “This ultimately lowers monthly mortgage payments, leaving more money in the hands of homeowners at a time when they need it most. If Congress does not act, the gains the housing market has made will be wiped away.”
The Washington Post reported on Friday that a number of former White House economic advisers and other economists consider the sagging housing market to be one of the greatest obstacles to recovery. Yet Treasury Secretary Timothy Geithner and others in the administration think there is little more they can do to help struggling homeowners, according to the Post.
Extending the tax exemption would help. The exemption, which can be as much as $2 million per household, covers individuals who negotiate a principal reduction on their existing mortgage, sell their house short (i.e., for less than the outstanding loans), or participate in a foreclosure process.
Under normal circumstances, homeowners who sold their house for less than the balance of the mortgage — and were forgiven the difference by the bank — would have to pay income tax on that windfall. Negotiating a reduction in the mortgage principal would also generate tax liability.
For example, an individual who owed a $400,000 mortgage might decide to sell the house, now worth $300,000 on the local market. If he sold the property short and the bank forgave the extra $100,000 — an arrangement that benefits the lender because it recoups more of the original loan than would a foreclosure — the IRS would consider that amount as income, on which the borrower could owe thousands of dollars in taxes.
“This has the effect of pulling people up with one hand, and hitting them in the face and knocking them over the cliff with the other,” Sen. Jeff Merkley (D-Ore.) told reporter David Dayen back in August.
An extension of the tax exemption would appear to be a common-sense means to help stabilize the housing market, but the political turmoil around the fiscal-cliff negotiations means common sense may not win out.
“The challenge is that a single-issue tax provision of this type — of any type, frankly — just simply doesn’t move on its own,” said Linda Goold, tax counsel for the National Association of Realtors. “It will be part of a package or it will not move. … It is really tied to the future of what happens with the big deal and then whatever they come up with after that relating to the provisions that either have or will be expiring.”
For more information, please see the IRS website with detailed information about the act.