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."
House Minority Leader Nancy Pelosi (D-Calif.) believes that the mortgage relief provision will be on the table during the grand-bargain talks, according to communications director Nadeam Elshami.
"Extension of this tax provision has passed by a bipartisan vote in the Senate Finance Committee, and we anticipate that it will be part of Congress' year-end negotiations," Elshami said. "Democrats hope to work with the House Republican leadership to support bipartisan measures which benefit the middle-class homeowners."
A senior House Republican aide said the provision would likely be dealt with as part of negotiations around a variety of tax exemptions set to expire at year's end. Those negotiations, he said, wouldn't begin in earnest as long as the fiscal-cliff talks were under way.
A spokesman for Senate Majority Leader Harry Reid (D-Nev.) said that Republicans declined to move the extension bill forward in the Senate Finance Committee. "Senator Reid tried to move the bill before we left, but was unable to get the Republicans to agree, even though it received strong bipartisan support from the committee," said Adam Jentleson.
"If you can't make your monthly mortgage payment, how on earth are you going to come up with $50,000 or so in taxes?" asked Rep. Brad Miller (D-N.C.), who led the push for the Mortgage Forgiveness Debt Relief Act when it first cleared Congress in 2007. "Principal reduction is by far the most successful kind of mortgage modification. If we can't extend the exemption, principal reduction is dead. Any bargain that doesn't extend the exemption won't be grand for the housing crisis."
Thousands of homeowners have taken advantage of the exemption over the past five years, but many more still need help.
"About 22 percent of the residential mortgages are underwater. That’s over 11 million households that would be hit with an additional tax if they were lucky enough to get a short sale or mortgage modification from their bank," McDermott said. "More importantly, the national foreclosure settlement requires a significant amount of mortgage modifications, which, if Congress does not extend this exemption, will be made useless."
According to CNN, more than 50,000 homeowners are foreclosed on each month, and around 500,000 have participated in short sales during the last six months alone. Under the National Mortgage Settlement reached last February between the federal government and five of the nation's top lenders, another 1 million homeowners could see their mortgage principal reduced.
Rep. Charles Rangel (D-N.Y.), who sponsored the 2007 law, is working with the House Ways and Means Committee to ensure that the exemption is on a list of tax extensions on which Congress is likely to vote this year, according to his office.
But Miller is less optimistic that Congress will make headway before Jan. 1, given that Republicans consider the measure to be a Democratic win. "Extending the exemption two years ago went down on the ledger as a give to Democrats," Miller said. "The only way it gets extended again is if the Obama administration insists that it has to be part of any deal."
Like McDermott, Rangel has introduced a bill on the House side, and Sen. Debbie Stabenow (D-Mich.) is championing a similar measure on the Senate side. Only Stabenow's bill has bipartisan sponsorship, and all three bills are stagnating in committee.
Even if Congress cannot extend the mortgage relief exemption this year, many note that a deal in 2013 would still be possible and could apply retroactively. But the heightened uncertainty would deter some underwater homeowners from selling their homes, and their negative equity would continue to drag on the housing market, Goold warned.
"We have already seen situations where people who are contemplating selling their home -- getting it ready to sell -- are not listing their homes for sale until this issue is resolved," said Goold. "The longer it drags out and the further into 2013, the more chilling effects the failure to extend the relief will have on the housing recovery."
Opponents of the mortgage relief exemption decry its cost -- an estimated $2.7 billion over the next two years -- and describe it as a reward for bad behavior that effectively lets homeowners off easy for buying more house than they could afford.
Douglas Holtz-Eakin of the American Action Forum told The Washington Post that many of the more conservative congressional freshmen have expressed a powerful opposition to the exemption. He predicted an "uphill fight" to get it passed.
But Goold counters that many of those homeowners did nothing wrong but were left stranded with expensive mortgages when the housing market imploded around them.
"I can be current on my mortgage, I could have made every single payment, and I could live in a zip code where values have gone down and be underwater," Goold said. "In that situation, particularly that situation, why would you ever want to put people in the position of having to pay tax on money they've already lost?"