Deal To Avert The Fiscal Cliff Doesn’t Do Enough To Help Underwater Homeowners

Our guest blogger is Julia Gordon, Director for Housing Finance and Policy at the Center for American Progress Action Fund.

As part of this week’s deal to avert the so-called “fiscal cliff,” Congress extended a little-known tax provision that says homeowners don’t have to pay tax on mortgage debt forgiven as part of a short sale or principal reduction. That’s great news for the millions of struggling homeowners that are “underwater,” meaning they owe more on their mortgage than their homes are worth, as they no longer have to fear a substantial tax payment shortly after working out a new agreement with their lender.

But Congress did not go far enough. In extending the provision as-is, lawmakers missed an opportunity to fix a blaring imperfection in the law that prevents more struggling homeowners from taking advantage of it.

The current law exempts only forgiveness of mortgage debt used to purchase a home or make major home improvements. As we recently pointed out in American Banker, if the homeowner at any point refinanced their mortgage with any “cash out” to consolidate bills, pay for minor home repairs, or cover education or medical costs, forgiven debt up to the amount of the cash-out is still taxable.

What’s more, treating partial amounts of the same mortgage differently adds a level of complexity that discourages all homeowners from taking advantage of the provision. For a homeowner to avoid a tax bill on their forgiven mortgage debt today, they must file two long and complex forms: a long-form 1040 for their first mortgage and a Form 982 for their other mortgage debt. If the IRS were allowed to treat all mortgage debt equally, this process could be drastically simplified.

This tax provision was initially passed in 2007, when the scope, depth, and impact of the housing bust were not yet clear. But if we’ve learned anything over the past five years, it’s that foreclosures have the same adverse impact on homeowners, investors, and neighborhoods regardless of what the underlying mortgage paid for. Since this tax provision aims to prevent foreclosures, it makes little sense for the tax code to differentiate between the two, and it adds unnecessary complexity.

In addition to streamlining the law, Congress should extend the tax protection permanently — or at least for far more than one year. Over the past few months, many short sales were hastily dumped on the market by homeowners afraid that this tax provision would expire, a distortion likely to occur again at the end of next year. Allowing it to expire at the end of 2013 will undermine any foreclosure prevention efforts that include debt forgiveness, including short sales, deeds-in-lieu-of-foreclosure, and principal reductions — a centerpiece of the recent Attorneys General settlement with mortgage servicers and an important component of the Obama administration’s Home Affordable Modification Program.

While the housing market is beginning to look up, millions of underwater homeowners continue to pose a threat to a lasting housing recovery. The last thing these struggling homeowners need is an unexpected tax obligation for money that they have never seen and their lender has agreed to forgive.