An unoccupied, foreclosed home in East Los Angeles in July. (Mel Melcon / Los Angeles…)
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 large 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 large amounts of 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 even with bipartisan support it's unlikely to get a vote before the November election.
And all bets are off on any legislation getting enacted in a turbulent post-election session later this year in which lawmakers must grapple with the divisive fiscal cliff issues.
As the clock ticks on the mortgage debt exemption, concern is rising.
"We are actively looking for opportunities to extend the provision, and we would hope we could do that well before the end of the calendar year," Housing and Urban Development Secretary Shaun Donovan said.
Mortgage debt that is 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 forgiven on a special Internal Revenue Service form.
But in 2007, Congress 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 exempted 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.
While the housing market recently has shown signs of turning the corner, housing advocates said the exemption is still needed.
It's 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 with federal and state officials.
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 under the settlement, averaging about $76,615 each.
A middle-class household would owe 25% taxes on that relief — about $19,000 for the average settlement relief so far. The tax would go up if the relief pushes the homeowner into a higher tax bracket or if the Bush tax cuts expire, as they are set to do at year's end.
"Principal reductions are coming, and we're glad for that, but they're less meaningful if there are tax consequences to them," said Kevin Stein, associate director of the California Reinvestment Coalition, a housing advocacy group.
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 from the three-year settlement, which became final in April, will come after this year.
"Extending this tax relief is critically important," said Lynda Gledhill, a spokeswoman for California Atty. Gen. Kamala Harris. Harris was a key player in the national mortgage settlement.
"It is difficult to imagine strapped homeowners able to take advantage of these and other market-restoring programs if they have to pay federal income tax on the principal reduction or short sale as 'income,' " Gledhill said.
A bill by Sen. Debbie Stabenow (D-Mich.) to extend the mortgage relief tax break through 2014 has 17 co-sponsors — 11 Democrats, four Republicans and two independents.
A one-year extension of the mortgage debt break was included in a broader tax bill that includes extensions of other expiring provisions. That bill passed the Senate Finance Committee last month in a 19-5 vote.
"There seems to be bipartisan concern about the issue," Donovan said.
The one-year extension of the mortgage debt relief exemption would cost $1.3 billion over the next decade, according to a congressional estimate.
McDermott's bill, which would extend the break through 2015, has 42 co-sponsors, all Democrats. But he was optimistic that Congress would act by the end of the year as more people realize the exemption is expiring.
"Suddenly, just when they throw you a life ring, they jerk it back," he said of the tax hit awaiting homeowners who received the benefits. "We cannot let this happen. It's going to be a disaster."