Senate action gives tax relief to short-sellers this year, not next

Reporting from washington —  For David Foster of Chicago, it was a stunning and welcome early Christmas present for him, his wife and three young children.

The Senate’s 11th-hour extension of the Mortgage Forgiveness Debt Relief Act through Dec. 31 will save Foster, who works for a nonprofit ministry group, from having to pay the IRS about $28,000 next year on $100,000 of mortgage debt canceled by his bank as part of a short sale on his condo. Before the Senate’s action, he told me he had no idea “how or where we could come up with” that sort of money.

The federal tax code treats forgiven debt as ordinary income to the borrower, taxable at regular rates. But under an exception that took effect in 2007, qualified home mortgage debt that is canceled by a lender as part of a short sale, loan modification or foreclosure is treated as nontaxable. However, that exception expired last Dec. 31 and its renewal has been in doubt all year — leaving short-sellers such as Foster unsure whether they would be facing crushing taxes in 2015.

Thousands of Americans who completed short sales during 2014 and received cancellations of mortgage debt by banks had reason to celebrate when the Senate extended the exception for transactions just before adjourning for the holidays. According to data from research firm RealtyTrac, nearly 122,000 short sales went to closing nationwide between January and October, involving an estimated average debt forgiveness of about $88,500. The average seller had a mortgage balance one and a half times higher than the market value of the house.

(Note to California homeowners: If your mortgage forgiveness occurred because of a short sale, you’re exempt from the tax because of an IRS interpretation of state law.)

In a short sale, an underwater homeowner agrees to sell the property to a new purchaser, typically for a price well below what is owed to the bank. If the bank agrees to the sale, the proceeds pay off part of the loan balance and the bank forgives — writes off — the rest.

Richard Eastern, chief executive of Washington Property Solutions Inc. in Bellevue, Wash., a brokerage specializing in short sales, says people such as Foster are the lucky ones. Substantial numbers of owners have been rushing to beat the Dec. 31 deadline.

“I got a call today from a client who asked, ‘We’re still scheduled for Dec. 29, right?’” Eastern recounted. The typical client served by his firm is an underwater owner with $300,000 of mortgage debt on a $200,000 house.

But Eastern said he has dozens of other listings where a 2014 closing won’t be possible, and some of these clients “are now devastated” in the wake of the Senate’s limitation of the extension to 2014 transactions. They could be plunging into a federal tax policy black hole when they complete their sales next year, uncertain of any further extension of the debt forgiveness law.

Eastern is mystified that Congress could not have lengthened the extension to two years — retroactive for 2014 and good through Dec. 31, 2015 — a provision approved in a bipartisan vote by the Senate Finance Committee last summer. He predicts that without protection from heavy tax burdens, many underwater owners will opt instead for bankruptcy filings. In some cases, they might be able to qualify for an “insolvency” declaration, which could wipe away tax liability for unpaid mortgage balances.

How do you know whether your short sale, loan modification or foreclosure is covered by the extension for 2014? Though a tax professional familiar with the law should be your best guide, here are the key tests you’ll need to pass: The house securing the mortgage debt must be your principal residence. The maximum amount of debt that qualifies for relief is $2 million ($1 million if you are married filing taxes singly.) Any portion of the mortgage debt forgiven that was used for purposes other than improving or building the house — say you refinanced, pulled cash out and used it to buy a car — will not qualify for the exclusion and may be taxable.

What are the prospects that Congress will extend the law for 2015, covering people who didn’t quite make the deadline for 2014? Not great. The Republican tax policy leadership in the House favors broad tax reforms in the upcoming session and wants to put an end to temporary tax code benefits that require periodic extensions. Unless proponents can make a strong case for mortgage debt relief as a permanent part of the tax code, it will be tough to get it extended again.

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Distributed by Washington Post Writers Group.