In 2007, a law was enacted to give homeowners tax relief as housing prices plummeted. But those big benefits are now gone.
The law was extended twice, but expired as of January 1, 2014. The end of the tax break will bring a lot of uncertainty to the housing market and could even hurt your home's value.
What is the MFDRA?
The Mortgage Forgiveness Debt Relief Act prevented homeowners who enter in to a short sale, principal forgiveness modification, or foreclosure from being taxed on the amount of their forgiven mortgage debt.
Before the law, any part of the mortgage debt the lender cancelled or forgave through foreclosure, short sale, or loan modification was considered part of the homeowner's income as far as the Internal Revenue Service was concerned, and was taxed as such.
The MFDRA gave tax relief by permitting homeowners to exclude this income on tax returns. The law was only applicable to primary residences and had a ceiling of $2 million that could be excluded each year.
How does this work? Here's the story of Mr. Tony Janega. Mr. Janega had been in the midst of a short sale on his home for the last three years. It was finally approved in the first week of February 2014. Because there was no extension, there is currently no tax exemption. His home sold for $125,000 less than what he owed on his mortgage, and that amount is now considered taxable income. When he files, Mr. Janega could owe the government upwards of $30,000 depending on his tax rate.
As you can see, this is a big deterrent for a short sale. That's also a big problem.
Short sales have helped stabilize the housing market
A short sale is a transaction where you sell your house for less than the amount on your mortgage -- as seen in Mr. Janega's example.
The recent housing crisis could have been a lot worse. However, both the federal and state governments mandated that banks forgive billions in mortgage debt. According to Black Knight Financial Services, banks have approved 2.8 million short sales since the law was enacted. In 2012, we saw the flood of short sales that actually helped to stabilize home prices.
Short sales are more preferential as a whole when compared to foreclosures. Both sell at discounts, but short sales happen quicker and have discounts that are usually lower than what would occur at a bank-owned or foreclosure sale. Lenders take a smaller hit and don't have to put that home on their books. The homeowner doesn't have additional months -- or even years -- of underwater property on their credit report. Local markets also don't have the burden of foreclosures weighing on neighboring property values.
Black Knight has also reported mortgages going through the foreclosure process are down about 28% from last year. At the moment, the issue is not the growing number entering the process, but the size of the backlog. Well over 3 million homeowners are late on their mortgages, and a little over 1.2 million are currently in foreclosure.
A way out for these borrowers could be a short sale or principal reduction loan modification. However, these options are not too appetizing at the moment with the now-relevant back-end tax hit.
How this could effectively slow down the housing recovery
Two weeks ago, Fitch Ratings announced it expects the number of short sales and principal forgiveness modifications to fall with the expiration of MFDRA.
It saw the lack of a tax exemption on forgiven debt as a disincentive for homeowners to enter in to a voluntary property sale that will not pay off a mortgage. This will cause a spike in involuntary foreclosures.
Right now, the measure does have bipartisan support. It has been lumped together with 55 other tax provisions, however, and it's doubtful it could pass on its own because of the fiscal costs.
We've heard a lot of good things coming from the housing market lately, but the recovery is still on tenuous ground. Homeowners who are currently underwater may hold onto their homes and hope that prices will rise enough to create an equity sale in order to prevent a substantial tax hit. However, as the late 2000s showed us, this landscape could be very bad for the housing market.