Just 7 Months Until Short Sales Have Ugly Tax Implications

Mortgage Debt Relief Act set to expire at the end of the year

Homeowners who experience principal reductions on their mortgages — through mortgage restructuring, foreclosures or short sales — have relied on The Mortgage Debt Relief  Act of 2007 to keep their tax bill from ballooning to alarming heights. The same Debt Relief act is scheduled to expire at the end of 2012.

From owing the bank to owing the IRS?

The Mortgage Relief Act means that as a homeowner, you are not required to include the amount of forgiven debt in your income when calculating taxes. That can mean a substantial savings on your tax bill — for instance, if your mortgage principal currently stands at $300,000 and you modify that loan or execute a short sale such that your principal is reduced to $200,000, that is $100,000 of debt forgiveness that would ordinarily be taxable as income — adding about $30,000 to your tax bill based on an average tax rate of 30 percent.

As Firedog Lake contributor David Dayen points out

“It will probably put you in a higher tax bracket. And because of the fact that, if you had that kind of money to throw around, you wouldn’t be a struggling borrower in the first place, you’re in no position to pay that tax bill. Even the insulting $2,000 given under the settlement to those foreclosed upon would get taxes, if the Mortgage Forgiveness Debt Relief Act expires. And the same goes for a short sale; the difference between the sale price of the house and the “true value” would be considered income, and taxed accordingly.

This is a total nightmare scenario for homeowners, the final indignity of the whole mortgage crisis.

No wonder short sales are so popular

Short sales have been on the rise, outpacing foreclosures in some states last year. RealtyTrac reported that short sales were up 25 percent in the first quarter of 2012 compared to the first quarter of 2011, while foreclosure sales were down by 15 percent in the same period. As a vice-president from RealtyTrac put it, for banks, “a short sale is a safer alternative to avoid any potential problems that they face because of the way they’re processing foreclosures.” (via The Washington Post)

Now’s the time

It’s unclear if the Mortgage Relief Act will be extended by Congress this year, so if you’re thinking of a loan modification or short sale, you have seven months to complete the transaction before it expires.