Congress has been urged to extend a $1.3 billion federal tax break on write-offs of mortgage debt that may expire at the end of the year even as lenders are increasingly cutting loan principal to help troubled borrowers.
The Mortgage Debt Relief Act of 2007 enables borrowers to avoid paying income taxes on the amount of principal that’s forgiven as part of a loan modification or during a short sale in which they sell their homes for less than they owe. If the measure expires, homeowners would have to count such debt reduction as money they earned.
“If these folks are going to have to pay tax on phantom income, it’s very impactful for homeowners,” Mark Goldhaber, a North Carolina mortgage industry consultant, said in an interview.
Whether Congress will act by the end of the year remains to be seen. The fate of tax break is largely bound up in the negotiations over the fiscal cliff. Though Democrats and some Republicans have called for the extension, the debt forgiveness measure would probably come as part of a broader package of tax-law changes.
The expiration of the tax break comes at the same time that federal policies are making short sales and other forms of debt forgiveness more common. Advocates for homeowners and mortgage industry participants say the break’s expiration could jeopardize progress made this year working through the backlog of troubled loans resulting from the housing market crisis.
The Treasury Department in January tripled the incentives it pays lenders for mortgage modifications to as much as 63 cents for each dollar of debt written off. In addition, the February federal and state legal settlement over foreclosure abuses requires the nation’s five largest lenders to cut about $10 billion in debt for troubled borrowers.
Meanwhile, Fannie Mae and Freddie Mac, the government-owned companies that back about two-thirds of all mortgages, streamlined their short-sale processes this year.
The effects are beginning to show: Lenders erased some of the principal owed in more than 11 percent of loan modifications in the second quarter of 2012, up 82 percent from a year earlier, according to data from the Office of the Comptroller of the Currency.
The monitor of the foreclosure settlement reported this month that banks including Wells Fargo & Co. and Bank of America cut about $2.55 billion in principal on first-lien mortgages and approved 113,000 short sales for another $13.1 billion in writedowns.
“With all of the work that has been done through the national mortgage settlement and through the Federal Housing Finance Agency with short-sale streamlining, all of that makes this much more urgent,” said Julia Gordon, director of housing finance and policy at the Center for American Progress in Washington.
Fearing that an end to the tax break could threaten progress on the settlement, 40 state attorneys general sent a letter to Congress this month urging its extension.
“Requiring a homeowner to pay income tax on forgiven or canceled mortgage debt would make the National Mortgage Settlement much less effective,” the letter said.
The Senate Finance Committee passed a one-year extension in August with a bipartisan vote of 19-5. The Joint Committee on Taxation estimated at the time that the cost to taxpayers would be $1.3 billion. The matter hasn’t come up for a vote of the full Senate, nor has it come to a vote in the House of Representatives.
The tax break applies to debt forgiven through the end of this year, making it possible for Congress to retroactively institute the change for 2013 sometime next year.
Still, advocates say a delay would create uncertainty and prevent some transactions. Meanwhile, some, including Gordon, are pushing for a broader overhaul of the tax break. Currently, the law counts forgiven debt from cash-out refinances as taxable income, and the advocates would like to see that exception dropped because it creates a large paperwork burden for everyone who claims an exemption from tax on forgiven debt.
“In a world where we’re talking about tax reform, this is just a great example of unnecessary complexity that helps no one and hurts everyone,” Gordon said.