Underwater Homeowners Running Out of Time to Seek Mortgage Liability Relief

With the Mortgage Forgiveness Liability Relief Act set to expire at the end of 2012, financially stressed homeowners are feeling the pressure to finalize short sales, foreclosures and loan modifications. If you’re upside-down on your home or you’ve already defaulted on your mortgage loan, you could be facing a hefty tax bill if you miss the deadline.

Protection for homeowners

Typically, forgiven consumer liability is treated as ordinary income and is subject to your regular tax bracket when you file. Prior to the passage of the Mortgage Forgiveness Liability Relief Act, homeowners were subject to federal income tax on all forgiven mortgage loans, regardless of the amount. For homeowners who canceled a substantial amount of their mortgage, the result was often a tax bill for tens of thousands of dollars.
In 2007, Congress passed the Act to help struggling homeowners reduce their tax liability for a forgiven mortgage or part of a mortgage. Specifically, the Act allows taxpayers to exclude canceled mortgage liabilities from income on their taxes if it is associated with the purchase, construction or improvement or their primary residence. Married couples filing jointly can exclude up to $2 million in canceled liability. The limit is $1 million for single filers and married couples filing separately. If the Act is allowed to expire at the end of the year, homeowners will lose federal tax protection.

Mortgage defaults expected to rise

With federal relief set to end, more homeowners may choose to strategically default on their home loans in order to qualify for assistance under the Mortgage Forgiveness Liability Relief Act. According to a May 2012 survey conducted by YouWalkAway.com, 34% of respondents based their decision to strategically default on the impending expiration of the Act. While the survey sampled only a small number of homeowners going through the foreclosure process, the results may indicate the potential for default on a larger scale. If strategic defaults increase, it could have a trickle-down effect on the housing market, which could directly impact homeowners attempting to secure short sales for deficient properties.

Congress considering an extension

In light of the continuing troubles in the housing market, Congress has taken action in an attempt to extend the Act’s protection through 2013. On August 2nd, Senate committee members were able to get enough votes to pass the extension before heading home for summer recess. It’s expected that the bill will go in front of the full Senate sometime later this year, although it may be pushed back until after the November election. While the need for an extension is evident among homeowners and the real estate industry, the bill has been met with opposition by some lawmakers who are concerned about the potential loss of tax revenue.

Weighing your options

If you’re concerned about the potential tax implications of canceling a portion of your mortgage, you need to evaluate your options carefully. If you’re underwater on your mortgage, a short sale may be the best way to avoid any additional tax liability. As long as you can complete the short sale by the end of the year, you’re still protected under the provisions of the Mortgage Forgiveness Liability Relief Act. Assuming you can find a buyer, the short sale process is typically faster and less costly than the foreclosure process.

One alternative to a short sale is a deed instead of foreclosure. You voluntarily surrender the deed to the lender in exchange for the cancellation of the loan. The lender agrees not to initiate a foreclosure proceeding or to cancel any foreclosure proceedings that have already begun. While a deed in lieu is a preferable alternative to a straight foreclosure, there is a catch in that not every lender may be willing to forgive any remaining balance resulting from the sale of the property.

While a short sale and a deed in lieu have negative implications for your credit, they may be the quickest route for resolving your mortgage. With the end of the year approaching, cash-strapped homeowners need to take action quickly to minimize their tax liability.