by Calculated Risk on 12/06/2012 10:15:00 AM

The Mortgage Debt Relief Act of 2007 is set to expire at the end of 2012 and this could have a significant impact on short sales. Usually cancelled debt is considered income, but a provision of the Debt Relief Act allowed borrowers "to exclude certain cancelled debt on [a] principal residence from income. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief." (excerpt from IRS).

If this act isn't extended, short sales could decline sharply. From Paul Reid, a Redfin real estate agent, writes:

"In an area like Orange County, where I work, the REO inventory is [minuscule]. As of this morning, there are 104 ‘Active’ REOs on the MLS in the entire county. In comparison, there is a total ‘Active’ inventory of 3,504 homes and condos. The short sale ‘Active’ inventory is 335. Where the numbers really stick out is in the ‘Pending’ sales category. As of right now, there are 6,059 homes in Orange County in escrow. Of those, only 267 homes are REOs. More than half, 3,216 homes, are short sales. The remainder are standard sales. If you remove the relief act from the equation you would likely see a significant drop in the number of short sales, but because of how slow the REO process is, you wouldn’t likely see a proportionate increase in the number of REO listings."

Right now there are a large number of pending short sales in many distressed areas. They all will not close before the end of the year.

There is a bipartisan push to have Congress extend the mortgage debt relief act. Here is a recent letter from several state attorneys general urging Congress to act.

As signatories to the National Mortgage Settlement, we the undersigned state attorneys general write to urge you to pass legislation extending tax relief for citizens who have mortgage debt canceled or forgiven because of financial hardship or a decline in housing values. Such legislation is currently included in Section 112 of the Family and Business Tax Cut Certainty Act of 2012 (S. 3521), which was recently passed out of the Senate Finance Committee with bipartisan support. We strongly urge Congress to extend this critical tax exclusion, which expires on December 31, 2012, so that distressed homeowners are not stuck with an unexpected tax bill or deterred from participating in this historic settlement.
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Under the federal Mortgage Debt Relief Act, in effect since 2007, mortgage debt that is forgiven after a foreclosure or short sale or through a loan modification provided to a homeowner in financial hardship may be excluded from a taxpayer’s calculation of taxable income. This exclusion only applies to mortgage debt forgiven on primary residences, not second homes. Unfortunately, this tax exclusion expires on December 31, 2012. Therefore, 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. According to the Congressional Budget Office, failure to extend this tax exclusion will result in $1.3 billion in tax increases on the very families who can least afford it.

I expect this act to be extended, but you never know.