Owners caught in tax-code limbo

Kenneth R. Harney

Jun 6, 2014

WASHINGTON – Is partisan warfare on Capitol Hill over taxation of medical devices crushing thousands of homeowners’ plans to do short sales this year?

Medical devices? What connection could heart pacemakers, dentures and LASIK eye surgery machines possibly have with short sales?

More than you’d probably guess. Just talk to Geoffrey Brencher, a high school teacher in Weston, Conn. For the past nine months, Brencher and his wife have been negotiating a short sale on their home, which has an underwater mortgage – the loan balance exceeds the property value.

The Brenchers recently received final approval from their bank to proceed with the sale provided the closing can occur no later than June 27. As part of the deal, the couple would get $75,000 of their mortgage debt canceled by the lender.

But here’s the complication- If they close and accept the debt cancellation, there is a serious risk under current federal law that the Brenchers could face a $20,000-plus income tax demand from the IRS. That’s because the Mortgage Forgiveness Debt Relief Act expired last Dec. 31 and its reauthorization is stuck in political quicksand in Congress.

First enacted in 2007, the law allows qualified owners who receive debt cancellations from lenders through short sales, foreclosures and loan modifications to be exempt from the federal tax code’s standard requirement- Any amount of debt that is forgiven by a creditor generally is treated as ordinary income to the borrower, taxable at regular rates. During the housing bust and its aftermath, the mortgage debt forgiveness exemption has proved invaluable to large numbers of owners who ended up – often through no fault of their own – with underwater mortgages.

With the expiration of the debt forgiveness statute, owners who do short sales during 2014 cannot be certain that they will avoid taxation on their forgiven mortgage debt. In the absence of a reauthorization by Congress retroactive to Jan. 1, there is a real possibility that short sellers in most parts of the country will face hefty income tax hits next year. (California residents are exempted on short sales because of an IRS interpretation of state law.)

Brencher, whose wife is expecting a baby in the coming months, faces a difficult choice. If he doesn’t close on the short sale, he loses an opportunity to relieve his family of significant debt. But if he sells and Congress doesn’t extend the law, he’ll be hit with “a tax bill that in no way can I afford,” he says.

The expiration of the law already is having impacts in the broader housing market. According to data from the National Association of Realtors, short sales have plunged from roughly 10 percent to 12 percent of home transactions in recent years to between 4 percent and 5 percent this spring. Some potential short sellers are opting for bankruptcy rather than taking a chance the law won’t be renewed. Kelli Meeks, an attorney in Ann Arbor, Mich., says three of her clients have given up on congressional action and filed for Chapter 7 bankruptcy. Six others are pondering what to do.

So what’s the holdup on Capitol Hill? In the Senate, the Finance Committee approved reauthorization of the mortgage debt law as part of a larger “extenders” package of tax benefits for a variety of special interests from wind energy to research and development credits.

But action stopped on the Senate floor when Majority Leader Harry Reid, D-Nev., refused to allow an amendment that would have killed a controversial 2.3 percent excise tax on medical devices that is a funding source for the Affordable Care Act. Republican critics of the health care law believe that an amendment eliminating the tax could pass the Senate, but Reid is steadfast in refusing to allow any votes before the November elections that could impact Obamacare.

In the House, Ways and Means Committee Chairman Dave Camp, R-Mich., is taking a go-slow approach on all tax law reauthorizations. There is no scheduled date for consideration of mortgage forgiveness.

All of which leaves the Brenchers – and many other owners around the country – in tax-code limbo. Congress may yet retroactively extend the debt forgiveness law late this summer or in a post-election lame duck session. Or even next spring. Tax analysts and lobbyists say that there is strong support for renewing mortgage forgiveness relief, and that the odds are better than even that it will happen.

Then again, with a fractious Congress, there’s just no guarantee.