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Originally published Tuesday, February 21, 2012 at 2:21 PM

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Mortgage relief faces a tax-law nightmare

The Mortgage Forgiveness Debt Relief Act — under which a reduction on mortgage principal as a result of a loan modification, short sale or foreclosure is not subject to federal income tax — will expire in 10 months, and there are early indications that Congress might not renew it by then.

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WASHINGTON — Given the huge public and private resources now being devoted to helping financially distressed homeowners — including the recently announced $25 billion national mortgage settlement with five major banks — you might assume that a key federal tax-law benefit underpinning these efforts would be a shoo-in for renewal.

But it's not. The Mortgage Forgiveness Debt Relief Act is set to expire in 10 months, and there are early indications on Capitol Hill that it might not make the cut. The law, first enacted in 2007, allows homeowners who have received principal reductions on their mortgages as the result of loan modifications, short sales or foreclosures to avoid income taxation on the amounts forgiven.

Loss of that tax help would endanger huge numbers of distressed mortgage arrangements in the months ahead. For example, the $25 billion mortgage settlement with 50 state attorneys general requires the banks to provide more than $10 billion in principal reductions to borrowers. Meanwhile, other lenders and mortgage servicers who are not parties to the settlement already provide principal reductions to troubled borrowers. Many of these owners would face hefty and ill-timed taxable income hits in the event the law is not extended.

Yet election-year politics and a contentious lame-duck, year-end congressional session loaded down with tax and budget issues could doom renewal of the debt-relief tax legislation and put large numbers of loan-modification participants deeply in the hole.

Republican strategists say the cost of continuing the program — $2.7 billion for two years — is substantial enough to catch the eye of budget-deficit hawks.

Beyond that, they add, some members of Congress may be opposed to what they see as still another targeted federal benefit for people who didn't pay their mortgages — subsidized by taxpayers who did the right thing and stayed current on their loans, even while underwater or facing severe financial distress.

Douglas Holtz-Eakin, president of the center-right American Action Forum, former director of the Congressional Budget Office and economic adviser to Sen. John McCain's 2008 presidential campaign, said in an interview that there is "a powerful sentiment," especially among conservative freshman House members supported by the tea party, that tax-code "bailouts" to delinquent and underwater homeowners are unfair.

"It's going to be an uphill fight" to get an extension through, he predicts. Real-estate and housing groups are worried about the same political dynamics and are gearing up campaigns to try to save the mortgage-debt-cancellation tax provisions in advance of the November elections — well before the expected year-end squeeze. Some industry lobbyists put the current odds of getting a pre-election, stand-alone extension bill through Congress at less than 50-50.

Here's what's involved, and how it might affect you or someone you know contemplating a short sale or loan modification that involves debt forgiveness. Before 2007, all cancellations of debt by creditors — whether on auto loans, personal loans or mortgages — were treated as taxable events under the federal tax code. If you owed $200,000, but paid off only $150,000 through an agreement with the lender, the $50,000 difference would be ordinary income, taxable at regular rates.

Under the debt-relief law for qualified homeowners, you can avoid taxation on forgiven mortgage amounts up to $2 million if married filing jointly, or $1 million for single filers. To be eligible, the debt must be canceled by a lender in connection with a mortgage restructuring, short sale, deed-in-lieu of foreclosure or foreclosure. The transaction must be completed no later than Dec. 31.

That impending deadline — and the risk that Congress won't reauthorize the law in time — has real-estate professionals and tax planners on edge already. "This is serious," said Harrison Long, of Coldwell Banker in Irvine, Calif. "Anybody thinking about doing a short sale this year needs to get moving on it now," given the long timelines needed to complete such transactions — often anywhere from four to 12 months.

Picture this scenario: You negotiate for months with your lender, realty agents and potential buyers. Finally you pull together a short-sale package calling for the bank to forgive $100,000. But the deal runs into hitches and doesn't go to closing until after the Dec. 31 expiration date. Now your house is gone, your credit is shot, you're looking for a place to rent, and the IRS demands taxes on your phantom "gain" of $100,000 on the sale.

With that sort of nightmarish liability on the line, it's worth it to gear up for action sooner, not later.

Ken Harney's email address

is kenharney@earthlink.net.

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