by Calculated Risk on 4/11/2014 09:42:00 PM

CR Note: Historically the IRS has considered debt forgiveness (like short sales) as taxable income. In 2007, Congress passed a measure to exempt most forgiven mortgage debt from being considered taxable income (this helped increase short sale activity). This measure expired on Dec 31, 2013. However, according to a letter from the IRS:

"[I]f a property owner cannot be held personally liable for the difference between the loan balance and the sales price, we would consider the obligation as a nonrecourse obligation. In this situation, the owner would not treat the cancelled debt as income."

So in states that passed anti-deficiency provisions (like California), this means many loans will be considered nonrecourse by the IRS (and forgiven debt will not be taxed).

However, in many other states, forgiven debt will be taxed.  There is little opposition to extending the debt relief act, and extending it would probably be helpful - especially in judicial foreclosure states (like New Jersey) where housing is still struggling to recover.

Note2: I looked for an update today after reading Dina ElBoghdady's article at the WaPo: Distressed homeowners seeking mortgage relief could get stuck with a big tax bill

This was written in February from Laurie Goodman and Ellen Seidman at the Urban Institute: The Mortgage Forgiveness Debt Relief Act Has Expired—Renewal Could Benefit Millions

Under the federal tax code, when a lender forgives part or all of a mortgage, the borrower must count that forgiveness as taxable income. Congress wisely recognized that this tax rule would discourage the forgiveness of debt as a tool to reduce foreclosures and add insult to injury for borrowers already struggling to pay their bills, many of whom had just lost their home. So in 2007, it passed the Mortgage Debt Forgiveness Act (the Act), which excludes this forgiveness from taxable income.

On December 31, 2013, the Mortgage Forgiveness Debt Relief Act expired.1 Unless Congress extends it, housing debt that has been forgiven or written off after 2013—through short sales, foreclosures, or loan modifications that include principal forgiveness—will generally be treated as taxable income. A bill that would extend the Act for two years has been introduced by Representative Bill Foster (D-IL), and many analysts predict that the Act will eventually be renewed. In the meantime, however, uncertainty over its renewal has made it increasingly difficult for lenders and borrowers alike to take actions that will be beneficial to both parties. We calculate this uncertainty will affect up to 2 million borrowers who are seriously delinquent or in foreclosure, many of whom will lose their homes, and as many as 1.4 million more who could potentially benefit from loan modifications that include principal reductions.

The case for rapid resolution is made more poignant by the fact that failure to do so contradicts other public policy initiatives. Last July, the U.S. Department of the Treasury extended the Home Affordable Modification Program (HAMP) for two years, until year-end 2015. HAMP loan modifications may include principal reduction, a technique that has proven especially effective in keeping homeowners in their homes. With the expiration of the Act, borrowers receiving principal reductions risk being taxed on the forgiven debt, sharply reducing the utility of the modification. Just as important, the large settlements between government regulators, lenders, and servicers are increasingly including commitments by institutions to provide significant sums of debt forgiveness. In the 2012 settlement between the State Attorneys General, the Department of Justice, and the nation’s five largest lenders, $10 billion of the $25 billion settlement was set aside for principal forgiveness. The actions under this settlement have been substantially completed but it has set the template for others to follow. In November 2013, JPMorgan Chase reached a $13 billion settlement with regulators over soured mortgage securities sold prior to the 2008 crisis; $4 billion of the settlement was set aside for consumer relief, which will take various forms, including principal reduction loan modifications. In December 2013, Ocwen reached a $2.2 billion settlement, with $2 billion to be used for principal reduction modifications. We can expect to see a series of additional settlements in the coming year, with much of the restitution in the form of principal reduction.

The timing of the expiration of the Mortgage Forgiveness Debt Relief Act is thus particularly unfortunate because it undermines the effectiveness of an increasingly utilized tool to reduce foreclosures. In this paper we describe the implications of the Act’s expiration and call for its rapid reenactment.