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Homeowners Who Negotiate Debt Relief Could Soon Face Massive Tax Bill

If Congress doesn't renew a key 2007 law, people who get a principal reduction on their mortgages or short-sell their homes could be forced to pay taxes on their "gain."

Feb. 23: This post has been updated.

You bought your house when the market was high and then lost your job. In order to avoid foreclosure, you negotiated a short sale for half of what you paid, ruining your credit rating for years and draining your bank account. But there is a tiny silver lining: Thanks to a 2007 law, you don't have to pay taxes on the $100,000 of debt your bank forgave as part of the short-sale agreement.

This week, real estate columnist Kenneth R. Harney pointed out that this important tax break will expire at the end of 2012 -- and, because of opposition from conservative members of Congress, might not be renewed.

The Mortgage Forgiveness Debt Relief Act of 2007 ensures that homeowners who restructure their mortgages or short-sell their homes don't have to pay taxes for reducing part of their debt.

Without the law, any cancelled debt typically counts as income. So an underwater homeowner who negotiated a principal reduction on her mortgage would have to pay taxes on that amount of "income."

The law creates an exemption for up to $2 million of forgiven debt on a taxpayer's primary residence.

Harney pointed out that the debt relief act provides a crucial underpinning to last month's $25 billion mortgage settlement, which requires five of the country's largest private loan servicers to provide $17 billion in principal reduction and other forms of foreclosure avoidance.

And given the importance of mortgage modifications and principal reductions to the Obama administration, you might think that the law would be on the fast-track towards further extension. (It was extended once before in 2008.)

But Harney reported that some conservative members of Congress may not approve of the program's $2.7 billion price tag, or of provisions they might perceive as a federal "bailout" of underwater homeowners.

"It's going to be an uphill fight" to get the law extended, economist Douglas Holtz-Eakin, a former McCain adviser, told Harney.

The debt forgiveness act originally had broad bipartisan support: It passed in the House of Representatives on a 386-to-27 vote. But among the Republicans who voted against the law in 2007 was now-Speaker of the House John Boehner. Boehner's office has not yet responded to a request for comment.

New York Democratic Congressman Charles Rangel, who sponsored the law, said that he plans to reintroduce it soon as part of this year's tax extender package.

"The issue for all the extenders is how we pay for them," Rangel said in an emailed statement. "While there may be resistance, this extension may very well be driven by public concern. Many of our nation's homeowners are still hurting from a housing crisis that has brought great financial instability and uncertainty -- they demand help and we must make sure their voices are heard."

The National Association of Realtors, which supported the original bill, is planning to make a "strong push" to get it re-extended.

"In light of how hard home owners were hit in the market downturn, it was unrealistic to expect households to pay tax on tens of thousands of dollars on forgiven debt when they lack money to pay their mortgage without a modification," Robert Freedman wrote on the association's Realtor Magazine blog.

In a video interview on the site, NAR's director of tax policy, Linda Goold, said there would be "very, very serious economic repercussions" if lenders and borrows remained uncertain about whether the law would be extended.

She said that the mortgage provision would be one of many tax laws expiring at the end of 2012, creating "an environment of remarkable chaos."

"Congress has always lumped the expiring conditions into one big package," Goold said. "That package has usually been, if not one of the very last things Congress did in December, pretty much close to the last thing Congress has done." She noted that it was unlikely that Congress would pass a single tax exemption separately from the others.

"It's the inability to get the process rolling that's our biggest obstacle," she said.

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