We All Benefit from the Extension of the MFDRA

The best real estate news this year is that the Mortgage Forgiveness Debt Relief Act of 2007 has been extended through the end of 2013. Until today, we thought it expired two days ago and went over the Fiscal Cliff. Without the extension of this Act, homeowners whose mortgage debt has been forgiven through loan modification, short sale or foreclosure would have the forgiven debt taxed as regular income.

For example, a homeowner owes $200,000 on his house, and his bank approved a short sale for $100,000, because that's all the house is worth in today's market. As far as the IRS is concerned, that homeowner has $100,000 in taxable income. If he is in the 28% tax bracket, if the MFDRA hadn't been extended, he would have owed $28,000 in income tax.

In order to qualify for a short sale, a homeowner has to prove he has a hardship: job loss, death, divorce, and moving out of town are among the few qualifying reasons. A homeowner who is capable of making his payments but just doesn't want to pay an underwater mortgage will not get much sympathy from his mortgage holder.

Homeowners who do qualify for a short sale are not likely to have thousands of dollars to pay income tax on money they didn't receive. Saddling homeowners with debt they can't pay is pointless for two reasons: 1) noncollectable income tax owned to the IRS won't help balance the Federal budget, and 2) defaulting on this obligation will prevent the former homeowners from getting back on their feet. Who wins in this scenario?

It is stressful enough for the homeowner to do a short sale, and the prospect of being responsible for income tax on income that wasn't received would have caused a lot more homeowners to walk away from their home. They would still have owed the income tax if the house were foreclosed, but the prospect of paying the tax bill would have given many homeowners a disincentive to jump through all the short sale hoops.

Foreclosed houses sell for less than short sale houses. These lower sale prices depress the value of nearby houses, putting more homeowners under water. The cycle of short sales and foreclosures will continue until we deplete the back log of short sales and foreclosures. Failure to extend the MFDRA would have dragged the housing market down and could have reversed the recovery we have enjoyed in the past year in Tucson.

Still to be resolved in debt reduction negotiations: whether the once-sacred mortgage interest deduction will be eliminated. Stay tuned.