Mortgage Debt Forgiveness Act Renewal Could Benefit Millions

By Laurie Goodman & Ellen Seidman, Urban Institute

The Mortgage Debt Forgiveness Act expired at the end of last year. What could happen if Congress chooses not to renew it?

If you were fortunate enough to sell your house with a $100,000 gain on January 15, 2014, how much of that gain could be subject to federal income tax? Likely none. Most gains on primary residence sales ($500,000 for couples, $250,000 for singles) are tax-exempt.

But what if you weren't so fortunate? Let's say instead of selling your house, you fell behind on your mortgage. You worked with your lender to lower the amount you owe by $100,000. That $100,000 would become "debt income" -- and potentially subject to federal income tax.

What about those less fortunate still? Let's say your lender foreclosed your house for $100,000 less than the debt accumulated on the mortgage. If you live in a state where the lender can't legally come after you (like Arizona, and for most foreclosures, California) you wouldn't owe any tax.  But if you live in a state like New Jersey or New York where you're still on the hook, and the lender didn't pursue you, you would lose your home and have $100,000 of taxable "debt income" to boot.

It sounds unbelievable. That's why Congress passed the Mortgage Debt Forgiveness Act in 2007 and extended it twice through 2013. The Act made most debt income from "principal reduction modifications" (mortgage loan modifications that reduced the amount owed), foreclosures, deeds-in-lieu of foreclosure, or short sales exempt from federal tax. Renewal bills have met little opposition in Congress, but remain in limbo.

Meanwhile, as we demonstrate in a concurrent commentary, over the next two years failure to renew the Act could affect 2 million delinquent or in-foreclosure borrowers. Many of these borrowers will lose their homes.

And as many as 1.4 million more borrowers could benefit from principal reduction modifications encouraged by the Act. This important settlement tool has a markedly better track record than modifications that reduce payments without also reducing the total amount owed. The Act also encouraged short sales, in which a borrower works with the lender to sell the house for less than the mortgage, a better deal than foreclosure for both parties. And the Act equalized the tax effects of a foreclosure across states, simplifying matters for everyone.

Estimating the cost of the Act's renewal is difficult because of likely extensive underreporting and because many borrowers who undergo foreclosure or get principal reduction modifications will be insolvent before the debt reduction -- exempting them from tax regardless of the Act. But if it means helping resolve the mortgage crisis more quickly, keeping families in their homes, and treating borrowers across the country equitably, the Treasury's $2.6 billion two-year estimate may be a small price to pay.

Laurie Goodman is the center director, and Ellen Seidman is a senior fellow, for the Housing Finance Policy Center at the Urban Institute. This piece originally appeared on the Urban Institute's MetroTrends blog.

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