Mortgage debt relief tax looms

WASHINGTON – Struggling homeowners who obtain reductions in their mortgage debt face a new obstacle starting next year: a bill for taxes on that aid.

A special exemption of as much as $2 million per household in principal reduction and other aid from banks, in place since 2007, is set to expire at year’s end.

It is one of a number of similarly expiring tax provisions – most notably the President George W. Bush-era tax cuts – and the automatic government-spending reductions looming at the same time that are referred to as the fiscal cliff.

Housing advocates and lawmakers are worried that the exemption will disappear just as thousands of homeowners are receiving mortgage debt relief from the nation’s five largest banks as part of a national settlement of foreclosure abuse investigations.

“The expiration of that provision is a hidden time bomb,” said Rep. Jim McDermott, D-Wash. He and other lawmakers are expected to push for an extension of the special tax exemption when Congress returns from summer recess next week, but it’s unlikely to get a vote before the November election.

Mortgage debt forgiven by a bank as part of a principal reduction, short sale or foreclosure must be reported as income by the homeowner and is subject to taxes. The lender reports the amount on a special Internal Revenue Service form.

But Congress in 2007 enacted the Mortgage Forgiveness Debt Relief Act to give struggling homeowners a break. If the debt is forgiven because of a drop in a home’s value or a decline in the owner’s financial condition, up to $2 million of the relief for couples filing jointly is exempt from federal taxes.

The exemption on what has been called shadow income – relief that can amount to tens or hundreds of thousands of dollars – originally was supposed to expire at the end of 2010. But with the housing market and economy in free fall in 2008, Congress extended the break until the end of the 2012 tax year.

The exemption is particularly important because the nation’s five largest banks – Bank of America Corp., JPMorgan Chase & Co., Wells Fargo & Co., Citigroup Inc. and Ally Financial Inc. – have begun providing principal reductions and other relief as part of a $25 billion settlement of foreclosure abuse allegations.

The government monitor of the settlement reported last week that the banks had provided a total of about $10.6 billion in aid from March 1 through June 30. Nearly 140,000 homeowners received some type of relief, averaging about $76,615.

A middle-class household would owe 25 percent taxes on that relief – about $19,000. The tax would go up if the relief pushes the homeowner into a higher tax bracket or if the Bush tax cuts expire.

Principal reductions received this year still will be eligible for the exemption when homeowners file their 2012 taxes next spring. But much of the aid will come after this year.