In the fall of 2007, after the sub prime crisis hit but long before the real decline hit the country in the gut, the Bush administration signed a bill into law that allowed regular borrowers to avoid a massive tax bill for the forgiven debt resulting from a short sale. Prior to that time, people who sold their home in a short sale would often get a 1099 for the discharged debt from their bank, causing them to sustain a tax liability. The Mortgage Forgiveness Debt Relief Act changed that.
It is a good law. Americans facing a foreclosure or short sale already face hardship and financial difficulty, to say nothing of stress. To have a tax bill for money you’ve never seen helps no one.
The law is set to end at the end of 2012. Unlike the tax stimulus of 2009 and 2010, which had to end sometime, the MFDRA should not have to end, certainly not anytime soon. The times we are in right now are actually worse than when the law was put into effect, and while it has helped untold scores of people, there are still more who would benefit from extending the law. Almost 30 million homes remain underwater and short sales remain a huge chunk of the market in many parts of the country.
Right here in Westchester County where a starter home can be over half a million dollars, a short sale can involve clients who are often underwater by six figures. To be destitute and forced from ownership with the accompanying credit consequences is bad enough; but to owe Uncle Same tens of thousands of dollars on top of that is unfathomable. The citizenry benefits from a capital gain exemption on their primary residence up to a quarter million for single person and half a million dollars for a married couple. If it simply isn’t the American way to tax people on a capital gain, why should those facing a more substantive hardship on a paper gain?
What will end up happening if it runs out is that more people facing an upside down mortgage (no equity) will instead elect to deed their house back to the bank or hunker down until foreclosure because they fear a massive IRS debt, pushing more foreclosures on the market than we already have to face. Foreclosures have already caused us here in Westchester to lose an average of 25% of property values since the peak, dramatically more in some places. We don’t need a single extra foreclosure. Owner occupant sales, short or not, are a superior alternative. If you complain that a neighbor did a short sale on their house, consider how you’d feel if the place were sold by the bank instead.
There is another consequence to allowing the law to run out, and that is the borrowers who start living off the societal grid out of fear of a ruinous IRS bill. We are starting to see people return to buying again after a short sale now. Would they do so if they had a big tax bill 4-5 years ago when they had a short sale? I doubt it. They’ll hide behind rented curtains the rest of their days. How does that help anyone?
We should extend the law another few years at least if we cannot make it permanent. The millions of people it was passed to help still need that help, and we should not witness them losing protection over something as unfortunate as timing.