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Tax Exemption for Mortgage Debt Relief Still Not Extended, Future Hopes Dim

The not-all-that-possible reduction or elimination of the mortgage interest deduction has set the hair of many a journalist on fire. Many of them have homes and benefit from that deduction, after all. And they cannot escape the fact that, if Republicans tell them that deductions have to be targeted instead of rates – which is ridiculous, since the rates are scheduled to go up automatically and higher rates above $250,000 will have a negligible impact on the economy – the mortgage interest deduction, among the largest and the most directly targeted at the well-to-do, will have to take the fall.

Far less ink has been spilled about the mortgage-related tax relief that actually is due to expire in just over a month, with a potentially massive impact on the housing market, in addition to being an indignity suffered by those struggling with the consequences of the collapse of the housing bubble. Ryan Grim and Sarah Bufkin took up my lonely crusade about the expiration of the Mortgage Forgiveness Debt Relief Act.

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.

The difference in the intensity of the coverage comes simply from the fact that the mortgage interest deduction impacts the peer group of journalists, while the MFDRA impacts primarily homeowners in trouble. The fact that the former is just in the discussion phase while the latter is really going to happen in a month doesn’t enter into the equation.

Meanwhile, the truth is that everyone will suffer from a failure to extend this measure. The National Association of Attorneys General wrote a letter to Congress yesterday explaining how failure to extend mortgage forgiveness debt relief will render impotent the foreclosure fraud settlement. Some of you will rightly note that the settlement is impotent all on its own. The majority of the relief granted so far has come from short sales. But those fall under this measure as well – recipients of a short sale would see the debt forgiveness under the sale treated as income for tax purposes. This would seize up all short sales, because the tax penalty would outweigh the benefit. Likewise for principal reductions. So as the NAAG writes, “Unless Congress acts, all of the remaining debt relief to be provided in 2013 under the National Mortgage Settlement, as well as other mortgage debt relief programs, will likely be considered taxable income.”

Short sales have helped drive the modest housing recovery so far. There’s no question that borrowers would be reluctant to agree to such a deal if it meant a huge tax bill. It’s true that borrowers could claim insolvency and then not be subject to the taxation. But tax insolvency is confusing and complex, and many borrowers – including short sale borrowers who have other assets and need to sell their underwater house to take a job, for example – won’t qualify. Just the threat of tax penalty will effectively end the short sale market.

This kind of tax provision is only going to move in a package, as I’ve been told multiple times. A one-year extension is in a larger “tax extenders” bill that passed the Senate Finance Committee before the election. However, that has to get in line behind whatever negotiation comes out to avoid the fiscal slope; Senate Republicans already declined to bring that bill to the floor and deal with it now. That could push the tax extenders bill into next year. They could make a MFDRA extension retroactive, but again, the threat is the problem. Lots of realtors have pushed to carry forward short sales to avoid the tax issue. There’s likely to be a bubble in those sales that will burst on Jan. 1 regardless. This will also lead to more foreclosures, in the absence of principal reduction or other debt relief as an option.

It’s such an invisible issue, I’m not optimistic it will get the proper priority. Yet when the housing market falters in January and everyone’s scratching their heads about it, you can remember this.

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David Dayen

David Dayen

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