The housing market crash of 2007 left millions of families with mortgages that were in excess of the plummeting values of their homes.  Many families opted to negotiate selling the property through a short sale. A short sale is a negotiated agreement between the lender and the borrower to sell the property for less than the amount of the mortgage. The borrower agrees to accept this “short” amount and typically cancels the remaining balance. The cancelled amount is reported to the IRS by the lender in a Form 1099-C. When an individual is given money that they do not have to pay back, the IRS typically treats the money as taxable income.

The “Mortgage Debt Relief Act of 2007” had made the cancelled debt on mortgages tax exempt.  The “Mortgage Debt Relief Act of 2007” was a relief to the targeted homeowners who were unable to afford the high-interest mortgage, but were also unable to afford the high taxes stemming from a short sale.  When a lender indicated on their 1099-C that the cancelled debt was through a negotiated short sale, the act allowed the IRS to exclude the discharge of debt from the borrower’s taxable income. The lender would then be given a tax credit for forgiving the remaining balance.

As of December 31st, the tax exemption protecting homeowners has expired. Homeowners are now forced to treat the debt relief as taxable income, while the banks will still be able to write off the debt as a loss against their income, thus saving money on reducing the amount of taxes they must pay.

As of January 1, 2014, homeowners opting for a short sale will see a massive increase in their taxes.  For example, a home-owner who had bought his house before the market crashed for $250,000, negotiated a short sale for $150,000.  The expiration of the tax exemption means that the home-owner will now have to treat the $100,000 relief as taxable income.   For example, if the home-owner is in the 33% tax bracket, that home-owner will need to pay an additional $33,000 in income taxes!

The Senate has introduced a bipartisan bill intended to restore the tax exemption and apply it retroactively to January 1, 2014.  The passage of the bill is uncertain due to Congressional attempts to overhaul the entire tax-code instead. The Senate Finance Committee has made no indication that they are taking the bill into serious consideration, and have avoided answering any questions pertaining to it.

There is hope that a bill retroactively applying the tax exemption will still pass this year. The Senate Finance Committee had been headed by Senator Max Baucus who had been hesitant in passing the bill and favored a complete tax overhaul. Now, Senator Baucus has been appointed as ambassador of China and the new head of the Senate Finance Committee, Democratic Senator Ron Wyden of Oregon, has a strong history of supporting homeowners. Last week, Wyden outlined his immediate agenda and made clear that passing a bill reinstating the tax credit will be a priority.  

For now, homeowners may still be able to apply for tax exemption under existing IRS rules - but the burden lies on the individual. The automatic exemption is no longer applicable. Under the Existing IRS rules, cancelled debts are exempt from taxes if the individual proves that they are insolvent. A person is considered insolvent if they prove that the total amount of all of their debts exceeds the total amount of their assets. Instead of having an automatic tax exemption after the lender filled out a 1099-C, an insolvent homeowner selling a house through a short sale is now personally responsible for gathering all evidence and applying for tax exemption via a Form 982.

I recommend that you call your members of Congress and tell them that you want them to extend the Mortgage Debt Relief Act of 2007.

UPDATE:  The law Mortgage Debt Relief Act was extended through December 31, 2015.