The Mortgage Debt Relief Act of 2007 allowed homeowners who completed a short sale, foreclosure, or loan mod from being taxed on the amount of their forgiven debt. The was law kept getting extended, but just expired at the beginning of this year, January 1st, 2014. The expiration still leaves millions of people wondering how they can exit from their underwater house
What is the Mortgage Forgiveness Debt Relief Act?
Before this law was put into play, any debt forgiven or cancelled through a short sale, foreclosure, or loan mod was treated like income, and taxed as such by the IRS. Essentially the MDRA allowed homeowners in distressed situations to exit more gracefully by not having to pay taxes on the cancelled or forgiven debt. There were exclusions, of course, mainly being that the home was a primary residence and the debt forgiven could not exceed 2M dollars.
Let’s look at a couple examples:
Janey Johnson owned a home that she lived in, and she lost her job in 2011. She missed payments and finally after 6 months the bank started the foreclosure process. She looked at her options, talked with local professionals, the lender, and decided a short sale would be a good option. She owed $250,000 on the mortgage, and realized the house was really only worth about $175,000 now. She sold through the home as a short sale in 2012, and did not have to pay any taxes on the $75,000 of forgiven debt.
Sammy Smith has been hanging on by a thread to keep his home, although it’s upside down, and he can hardly afford it. He finally stopped making payments in 2011, and the bank, because of their backlog of homes, did not start the foreclosure proceedings for over a year. He didn’t qualify for a loan mod, so the bank agreed to let him attempt a short sale. However, the short sale has drug on for over a year, and did not close until February 2014. His house sold for $75,000 less than what he owed too, but that amount is now considered taxable income. Depending on his tax rate, he could owe $18,000 or more.
In the past, exiting through a short sale and capturing the debt forgiveness was a big incentive. Now, it’s effecting homeowners that are stuck between a home that’s lost significant value whom are left questioning their best options.
Why Short Sales Help the Market
Unless you’ve been living under a rock, you probably understand the basic concept of a short sale. Basically, it’s when you sell your home to a Buyer, and the existing lenders on the property take less than what they’re owed, just like in our two examples.
If the government had not stepped in to enact the MFDRA, the recovery could have taken much longer. Although the programs were clunky at best in the beginning, millions of people in the US have completed a short sale. In the bust, a flood of short sales actually stabilized home prices by creating a win-win-win for Sellers, Buyers, and Banks.
The incentives for Buyers were that they could get the house at a significant discount, sometimes more than an REO property. I wrote an article about why short sales are still a good avenue to find deals not too long ago.
For Sellers, besides capturing debt relief, the tarnish on their credit was typically lessened than if they had pursued a foreclosure. For banks, recouping some of their investment in a more timely manner was motivation enough to work with their distressed population, rather than becoming property managers, renovators, and owners.
How the expiration of the MFDRA could slow down the Housing recovery
Fitch Ratings announced two weeks ago that it expects the number of short sales and principal forgiveness loan mods to fall now that the MFDRA expired. With less incentive for the homeowners, this will cause an uptick in involuntary foreclosures.
Another extension of the law has been tabled again, but it’s lumped in with 55 other tax provisions. Although it has bipartisan support, the fiscal costs alone make it doubtful that it will pass again.
We’ve been hearing that housing is back, but the truth is, the recovery has not lifted wages, jobs, and housing appreciation to a level that can solve the lingering issue: how can people get out of their underwater homes, and who is going to buy them if investor activity has waned, and first time home buyers aren’t as interested in homeownership as we expected them to be?
What do you think? Although short sales may seem like a ghost of markets past, do you think the expiration of the HFDRA will stall the market recovery?