One of the worst consequences of our prolonged economic slump is that the market value of real estate has nosedived. As a result, millions of homeowners now face the difficult reality that the market value of their home is less than the balance of their mortgage. They are underwater homeowners.
Under normal circumstances, underwater homeowners who sell their houses for less than the balance of their mortgage, and are forgiven the difference by the mortgage company, a process known as a "short sale", would need to pay income tax on the amount forgiven by the mortgage company. IRS considers the cancellation of a debt to be income. Similarly, a homeowner whose loan balance is reduced through a mortgage loan modification would have income tax liability on the income "created" by the cancellation of that portion of the loan.
For example, consider an individual who owed a $250,000 mortgage, but was only able to sell his house for $200,000 in today's depressed real estate market. The mortgage company accepts the $200,000 (less settlement charges) in full settlement of the $250,000, canceling $50,000 of debt. Under the tax law, the cancellation of the $50,000 in debt would be treated as $50,000 of income. The homeowner would be required to pay income tax on the $50,000.
In 2007, though, Congress enacted the Mortgage Forgiveness Debt Relief Act. This Act exempted from tax liability up to $1 million per person, $2 million per household of income imputed to homeowners by the cancellation of mortgage debt by consent of the mortgage company though a short sale or a mortgage loan modification. The Mortgage Forgiveness Debt Relief Act expired on December 31, 2012, the date of the fiscal cliff. Expiration of this tax exemption would have further hindered any housing recovery and severely limited valuable options for underwater homeowners.
Fortunately, in the maelstrom of the fiscal cliff negotiations, Congress included a one year extension of the Mortgage Forgiveness Debt Relief Act. The Act will now expire on December 31, 2013. Hopefully, there will be more progress on a housing recovery this year. Even better, it is just common sense to make this exemption a permanent part of the tax code, so homeowners will not be faced again with a wiped out loan being treated as taxable income.