Mortgage Tax Relief to Die? Pt. 1

In 2007, in the midst of the recent real estate and mortgage collapse, Congress enacted the Mortgage Forgiveness Debt Relief Act. The intent of this law was to stop a very punitive tax that millions of distressed homeowners were facing.

This was a tax on income, but oddly an income that homeowners never received, because it was a “forgiven” or a so-called “imputed” income.  Millions of homeowners nationally were facing huge bills from the IRS for unpaid taxes for phantom income, money never received, and many of these were from California, Arizona and Nevada, states severely hit in the mortgage meltdown.

Originally the tax worked this way, imagine that a borrower took out a home loan for $500,000; then they suffer a job loss and can no longer afford the home. The property is then sold with the banks permission by a short sale or foreclosed upon, and in the end the lender is only repaid $425,000 from the sale or auction.

The homeowner now is subject to an “income” tax on the $75,000 that was “forgiven” or “imputed” by the bank.  In the midst of their financial crisis the can not afford to pay the tax.

In 2007, Congress moved to help distressed homeowners by changing the rules.  Via the Debt Relief Act Congress exempted as much as $2 million in forgiven homeowner mortgage debt that now became non-taxable ($1 million if married filing separately).  Unfortunately the law was valid only until the end of 2013.

Unless the legislation is extended large numbers of troubled borrowers will again face huge new taxes.  The result may be that many distressed borrowers may face the unfortunate incentive to go to foreclosure rather than seek a short sale in order to avoid the huge tax bill.

Without tax forgiveness foreclosure levels might begin to rise significantly because fewer borrowers will be inclined to engage in a short sale.  Continued in second blog.