The 113th Congress may be considered a do-nothing Congress, but they did manage to take care of some business during the lame duck session in December, including the passage of an early Christmas present to home sellers who sold their homes in short sales during 2014.
Congress passed a bill that extended the Mortgage Forgiveness Debt Relief Act (MFDRA) through December 31st of 2014. The act, originally passed in 2007, waives the tax on the amount of debt forgiven during a short sale or foreclosure. It has been extended several times in the past and was allowed to expire at the end of 2013 – leaving those with 2014 short sales in limbo for most of the year.
A short sale occurs when a mortgage lender accepts a sale price that is less than the amount that the current borrower owes on the home.
Homeowners who owe more on their home than it is worth (“underwater” homeowners) often rely on short sales. They attempt to convince the bank to accept less money from the sale of their home to pay off the majority of the balance and forgive the rest of the debt. Banks may agree, preferring to receive a majority of the funds owed to them instead of dealing with defaults and foreclosures.
The amount of debt forgiven has historically been considered as taxable income. From an accounting standpoint, it is no different from the homeowner receiving the forgiven debt amount from any other income source and using it to pay the bank.
The MFDRA avoids the tax by classifying forgiven debt as non-taxable income, which is a huge break for short-sellers. Consider that in a 28% tax bracket, every $100,000 of forgiven debt (not an unusual number in the housing crisis) would require $28,000 in taxes. If you have just gone through a short sale, it is almost guaranteed that you do not have an extra $28,000 available to pay this tax.
With this extension, homeowners who closed on their short sales before the December 31st deadline are breathing sighs of relief. Those who missed the deadline and closed in January (or will close later in the year) will need extra antacids while they hope Congress extends the MFDRA yet again to cover 2015. It is anyone’s guess whether Congress will do so.
Previous extensions covered multiple years, so a single-year extension makes those counting on the MFDRA in 2015 quite nervous. The incoming Republican Congress is expected to look at broader tax reforms instead of piecemeal extensions of various benefits.
The original act was intended to be temporary until the housing market recovered. Arguably, it has not recovered yet, so there may still be a window of time to convince Congress that MFDRA must be extended until the housing market has fully recovered. However, the best hope for short-sellers is that the MFDRA is integrated to become a permanent part of the tax code. Both cases will be difficult sells in the 114th Congress.
If you missed the deadline and your short sale closed in 2015, it is wise to hope for the best but plan for the worst.
Assume that you will be stuck with taxes on the forgiven debt, and use your time during the year to rebalance your budget and scrape together as much of the taxes as possible. You may want to consult with a tax expert to look for other ways to reduce your tax burden… and sending a letter to your Congressman to urge extension of the MFDRA cannot hurt. Remember, better to be taxed on forgiven debt than not have your debt forgiven.