Hurry Up on Short Sale if You Don’t Want to be Slapped with Tax Next Year

Congress needs to act, or forgiven mortgage debt won’t be forgiven next year.

Update: Congress extended mortgage cancellation relief through the end of 2013. So the portion of a mortgage forgiven as part of a workout plan, short sale, or foreclosure before Jan. 1, 2014, won’t be considered part of taxable income.

At the same time that a bright spot has emerged for struggling home owners trying to get a short sale closed — Fannie Mae and Freddie Mac now require shorter short sales from lenders they work with — there’s a looming cloud.

Unless Congress acts this year, short sale sellers will be in for an income tax increase in 2013.

Let’s say you owe $150,000 on your mortgage, but your REALTOR® finds a buyer willing to pay $120,000. The bank approves the short sale and forgives the $30,000 difference. If you don’t complete the sale by Dec. 31, 2012, as of Jan. 1, 2013, that $30,000 in forgiven mortgage debt will be considered taxable income by the IRS.

It hardly seems fair, given that that the reason the lender forgave the debt in the first place was to facilitate the short sale — and help an underwater home owner climb out of financial hardship. Now, those home owners will be responsible for paying a new tax on “phantom” income. And it’s not just debt forgiven in a short sale that would be affected: The same tax hike would apply to home owners who work with their lenders to restructure their mortgages if they’re granted debt relief.

Back in 2007, Congress passed a law designed to protect home owners from the tax, but that protection expires at the end of 2012. However, one Senate bill recently introduced by Sen. Debbie Stabenow (D-Mich.), — and two House bills — recently introduced by Reps. Charles Rangel (D-N.Y.) and Tom Reed (R-N.Y.) — seek to extend the law and eliminate the new tax. The Stabenow and Rangel bills would extend the expiring law for two years, and the Reed bill would extend it for one year.

“Mortgage debt forgiveness is not disposable cash for the mortgage holder,” Reed said in a statement. “Piling additional burdens on people at such a difficult time makes their precarious situation worse.”

“It’s bad enough that so many families are faced with mortgages that now exceed the value of their home,” Stabenow said in a statement. “But to add insult to injury, without this bill, the IRS would once again require these families to pay hundreds or thousands of dollars in additional income tax when they sell or refinance their home. That’s just wrong.”

There’s time yet for Congress to pass one of these bills — or better yet, make debt foregiveness relief  permanent — but with so much uncertainty in the housing market, legislative action can’t come soon enough.

Do you think Congress will act in time, or do you think struggling home owners will get hit with a new tax?