Tax break for underwater homeowners set to expire

The clock is ticking on a tax break that saves struggling homeowners from paying thousands of dollars to the IRS.

If the Mortgage Forgiveness Debt Relief Act of 2007 does not get extended by Congress by the end of the year, homeowners will have to start paying income taxes on the portion of their mortgage that is forgiven in a foreclosure, short sale or principal reduction.

Should the tax break expire, a large number of mortgage borrowers could be affected. More than 50,000 homeowners go through foreclosure each month.  

So if you owe $150,000 on your home and it sells for $100,000 in a foreclosure auction, the IRS could tax you on the remaining $50,000. For someone in the 25% tax bracket, that would mean paying $12,500 in taxes on the foreclosure. Similar taxes would apply for forgiven amounts in short sales and principal reductions.

“If there ever was a no-brainer in housing policy, this would be it,” said Jaret Seiberg, a policy analyst for Guggenheim Securities. Yet, Seiberg is skeptical the exemption will get extended. Now that the election is over, he thinks Congress will be heading into a “lame duck” session, with very little legislation moving forward through the end of the year.

Even if Congress allowed the exemption to expire, not all borrowers with forgiven mortgage debt will take a tax hit. If the debt is discharged in a bankruptcy, no tax is due. And anyone who is insolvent — meaning they have more debt than assets — at the time the debt was forgiven — would not have to pay the tax.

Also, in California certain borrowers are protected against paying the tax because of the way the state treats foreclosures.

In addition, the cost of the exemption could make it a point of contention. The office of Sen. Max Baucus, who heads the finance committee, estimated the cost of a one-year extension at $1.3 billion.

Source:  Les Christie @CNNMoney
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