The Looming Burden For Underwater Homeowners That No One Is Talking About


Since the start of our housing crisis, struggling homeowners have had few places to turn for relief. Now, thanks to settlements between the federal government and banks and mortgage servicers, some borrowers will be able to get relief from their massive debt and unaffordable mortgage payments. But if Congress fails to act by the end of this year, many struggling homeowners who get this relief will face a new problem: a huge tax bill.

At issue is whether underwater homeowners — those who owe more on their mortgage than their home is worth — should be taxed on mortgage debt that their lenders agree to forgive. Since the passage of the ‘Mortgage Debt Forgiveness Relief Act’ in 2007, homeowners haven’t been taxed on this debt. But starting January 1, forgiven debt will again become taxable, imposing huge penalties. For example, an underwater homeowner who earns $40,000 a year and is able to receive $100,000 in debt relief would see her taxes balloon to nearly three-quarters of her income.

Both short sales, where underwater homeowners are allowed to sell their homes for less than they owe on their mortgages, and principal reductions, where a lender agrees to reduce the amount of money a homeowner owes on a mortgage, will be rendered essentially useless if forgiven debt is taxed. As a result, underwater homeowners have even fewer options to escape their debt, communities will suffer from more foreclosures, and banks and investors will lose access to tools that limit their losses on mortgages.

Additional urgency comes from the pending settlement over mortgage practices between JP Morgan and the Justice Department, which is rumored to contain $4 billion in homeowner relief. But if Congress fails to exempt this relief from taxation, much of it will be of little help to homeowners.

Uncertainty over whether the act will be extended is also highly damaging to the real estate market. Short sales have become more and more common in recent years, now accounting for 15 percent of all home sales. But as we approach the end of the year, realtors and homeowners—unsure of the status of the law—will be less and less likely to pursue short sales.

While home prices have risen in recent months, Congress would be wrong to assume that our housing crisis is over. More than 7 million homeowners – or 15 percent of all mortgages – are still underwater, and more than 6 percent are underwater by more than 25 percent of their home’s value. Home prices are still more than 20 percent below their peak. Price increases are highly uneven across the country and even different neighborhoods, and it’s unclear whether the increases will be sustainable.

Because Sen. Max Baucus (D-MT) and Rep. Dave Camp (R-MI) want to pursue comprehensive tax reform this year, they have refused to consider an extension of this act or any other temporary tax breaks.

There is a path forward in the Senate, where Sens. Stabenow (D-MI) and Heller (R-NV) have introduced a bill to renew the act for two more years. A push to extend the act for 2013 was successful last year: A one-year extension was included in January’s last-minute fiscal cliff deal. But further extension of the act has gotten little attention on the Hill this year.

David Sanchez is a Research Assistant for Housing Finance and Policy at the Center for American Progress Action Fund.