Relief Act Expiration Leaves Underwater Homeowners Troubled

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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.

Related: What is a Short Sale? The Definitive Guide

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?

About Author

Tracy Royce

Tracy (G+) is an Arizona Short Sale Realtor, Investor, Rehabber, and Foreclosure Expert. She also is an avid blogger, vlogger and consultant on all things Arizona Foreclosures.


  1. Always a fan of free markets, the reason for our present uncertain and unstable present market is our government has the belief its job to to micromanage everything.

  2. OK Tracy, a sad fact is that banks do not care, if you sign a note, you owe the balance period.

    Strategic Defaults, folks not paying on purpose, should these people not pay because it is not convenient? Not trying to be harsh, but if you sign a note, shouldn’t you be accountable?

    Let’s focus on GOOD alternatives to short sales, or avoiding short sales. If agents-realtors were workout specialists, being paid an hourly wage, not on a 6% commission, but advising home owners on how to lease their home long term, and perhaps “feeding” a negative cash flow to get rid of an asset that has a negative value (upside down) and protect their credit record, that would serve the seller much better than a “pipe dream” of a bank “forgiving debt”.

    Lease Purchase long term can be an option to assist a home seller upside down. Charge market rent plus perhaps a bit more in the form of an additional option payment could pay a PITI for a Seller that cant sell an underwater home.

    -Say 12 month lease with 9 possible extensions if lease is paid on time.
    -Say option price is new appraisal. If the appraisal is lower than loan payoff, then the lease will be renewed for 12 months.

    The “maybe” of short sales and the possible “clawback” of the IRS charging you for the phantom income is ridiculous and heart wrenching for a home owner to put up with. See

    For an agent, while having good intentions, talking about a short sale solution that may or may not have a good result, with tax liability or actual debt forgiveness from the lender, this might be ill advising their home seller client. The get out of jail free card of Mortgage Forgiveness Debt Relief Act is now over.

    No other Western country, e.g Canada, U.K., etc, has allowed so many short sales and debt forgiveness practices. Maybe 3.5% FHA down payments are not enough “skin in the game” for home ownership; like Canada, maybe 20% down will be the norm.

    Looking at Seller Financing over 10 years could be the only real and effective solution for underwater homes.

    See Chapt 10 – Creative Financing of Gary Keller’s SHIFT book

    • I could agree with your approach Brian should it not be for the fact that you’re assuming these distressed homeowners would make better landlords than they do homeowners. Lease options can be complicated. I would also imagine that these homeowners aren’t going to pay to have an attorney review their leases and option, or know how to efficiently run a rental and have the headache of that for 10 years (if not more). If the tenant decides to exercise their option and the house is still upside down, then what? Convince the tenant to pay over market price and have the seller carry a note? There’s just a lot of layers with this theory that I don’t think would be practical en masse for the average person. I agree that hedging bets on the front side would lessen the default rate. But, responsible lending doesn’t lead to financial turmoil, which big banking needs. Our ground level solutions are “cute” to them, I’m sure.

      • Well Tracy, it looks like, unless Congress changes something, if you signed a note (mortgage DOT) and your upside down, you need to take the bull by the horns and rent it out or sell it on terms, to save your credit.

        I like a long term lease option where the option price is new appraisal and the seller contributes to paying down the negative.

        Even if you (the owner) are paying down $200 a month extra x 12 months x 10 years = $24,000, plus a little appreciation might get people some relief, not in all RE markets but some.

        Definitely better than a “maybe” short sale, IMHO.

  3. Dawn Anastasi on

    At what point is the “date” in which the foreclosure becomes a taxable event? If the bank filed for foreclosure last year, but the sheriff’s sale is this year, do they qualify or not?

    • Dawn it’s all hinged on when title changes hands. Filing date for the foreclosure doesn’t matter at all, only matters when the existing homeowner no longer holds title to the property. So whenever that date occurs, is when the taxable event occurs. If the Sheriffs Sale happens this year, the MDRA does not apply.

  4. Stuart Stevens on

    California and possibly some other states have identified that the forgiveness o debt is still possible.

    The good news in 2014 is that the California Franchise Tax Board has clarified that California families who have lost their primary home in a short sale are not subject to California state income tax liability on debt forgiveness “phantom income” they never received in a short sale on their primary residence (1-4 units) with a non-recourse, purchase money loan. A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default.

    Short sales are still active in California although the majority of foreclosures have closed due to the non judicial mortgage loans.

    • Stuart we have long-enacted laws here that protect Arizona homeowners that hold non-recourse debt, as well. It’s a layer of protection for qualified homeowners that certainly helps underwater homeowners making decisions to foreclose or attempt a short sale.

      We’ve also gotten through the majority of our foreclosures, since like you (CA) we’re non-judicial as well. Thanks for sharing!

  5. The bill to extend the act is waiting to be reviewed now. I am guessing it will be renewed and made retroactive.

    I agree it needs to be renewed. I find it hardly fair that a seller tries to do the right thing by doing a Short sale and then get hit with a massive tax bill they will never be able to pay.

    • Homeowners are just paying repeatedly for the “sins of the father”, IMHO. Have you seen what Freddie and Fannie are trading at lately, Mark?? Part of me wants to see the government retract and let this mess clean itself up, the other half wants them to continue to help clean it up because we’re in it because of THEIR policies, or should I say lack thereof?

      There’s still the insolvency qualification a lot of homeowners with (said tax bill) will most likely be able to claim.

  6. To short sale or not to short sale, that is the question. The answer to me at least would be Yes. Even without the tax writeoff Because if you short sale you could try to get the bank to forgive the shortage of what you owe verses what the house sold for. If they dont you could live in the house like forevever without paying until they finish the forclosure and get you out If you don’t short with dept forgivness the bank will come after for sure for the shortfall plus you will still owe the tax. By the way I did not buy more house then I could afford and am not behind on any dept.

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