The new year brings bad news for mortgage borrowers who were granted debt forgiveness. That money now can be treated as income leading to unexpected and unwanted income tax obligations.According to IRS regulations, if a family is behind on its mortgage and the bank reduces the borrower's loan principal or forgives the mortgage balance after a short sale, in which the seller owes more than the selling price, the amount of debt forgiveness would be taxable income, despite the fact that these are paper profits. These rules also apply to foreclosed property.

For example, let's say that a homeowner purchased a home at the peak of the market for $750,000, but sold it in a short sale for $500,000. Currently, that $250,000 would be taxed as income, even though it was phantom revenue and never changed hands.

Mortgage Foreclosure Debt Forgiveness Act
In 2007 after the mortgage meltdown, Congress passed the Mortgage Foreclosure Debt Forgiveness Act. Up to $2 million of debt forgiven by foreclosure, short sale, or loan modification qualified for tax relief. The law was extended twice, but finally sunset Dec. 31, 2013.

As of this writing, Congress is unable to agree on paying its own already authorized bills and faces another potential government shutdown in mid January. Since the lapse of the Debt Forgiveness Act will bring in more revenue, some in Congress aren't eager to restore it. However, it will make life difficult for somebody who could not afford to pay a mortgage or shell out taxes on debt forgiveness.

Today, the only protection for these homeowners lies in the tax code's insolvency exclusion. Borrowers are deemed insolvent when their debts are more than the fair market value of their total assets. If this situation applies, some or all of the cancelled debt may not be taxable.

Improvements, but not housing market not fully recovered
The real estate market improved significantly last year. Foreclosures are at the lowest levels in seven years. According to RealtyTrac, 37 percent fewer properties had a foreclosure filing in Nov. than in the same month a year before with a total of 113,454 properties. Filings are significantly lower than the monthly average of 300,000 during the depths of the financial crisis.

Fewer people are facing the loss of their homes so the tax break does not have the urgency it once had. In fact, bills to extend it are stuck in committee. It is useful to take a longer perspective. When the real estate market was still strong in Dec. 2005, only 49,236 U.S. properties started the foreclosure process.

The U.S. real estate market has not fully recovered. According to Zillow, 11 million homeowners still have negative equity in their homes. That is more than the number of residents in 43 states. Although bank repossessions dropped overall to a 76-month low, five states showed increases in Nov. compared to the year before: Delaware by 179 percent, Maryland by 41 percent, Connecticut by 9 percent, Maine by 6 percent, and Iowa by 2 percent.

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