The Mortgage Forgiveness Debt Relief Act of 2007, which was set to expire December 31, 2012, has survived and has been extended to January 1, 2014. This is good news for our newly recovering housing market. Although the Senate missed its deadline of midnight December 31, they decided to enjoy the holiday and reconvened on January 1in the evening. Along with the largest tax increase our country has ever seen, was the expiration of debt relief.
Without this law, the forgiven debt would be treated as taxable income and the homeowner would be hit with a tax bill. To use an example from the Wall Street Journal, Market Watch, a homeowner in the 25% tax bracket that is underwater on their mortgage: they owe $200,000 and short sell for $150,000, leaving $50,000 of forgiven debt. The homeowner would owe $12,500 in taxes.
Compass Point Research and Trading says, "The amount extends up to $2 million of debt forgiven on the homeowner's principal residence," meaning; "For homeowner's to qualify, their debt must have been used to 'buy, build, or substantially improve' their principal residence and be secured by that residence. The law, which was passed in 2007 with a 5-year sunset provision, will now be in effect until Jan. 1, 2014."
Allowing this law to expire would have forced many underwater (negative equity) homeowners into foreclosure. Why would a homeowner agree to short sale if they will be taxed on it? The same goes for a loan modification or principle reduction, which has proven to be more successful than most modifications.
The average principal balance reduction is $150,000, and more than 13,000 were executed in November alone. Short sales in the third quarter alone were over 98,000. You can see how this is vital to reducing the shadow inventory. Right now, the shadow inventory is 2.3 million, which is a 12% reduction from 2011. More short sales result in destabilizing prices if not priced accurately, but short sales reduce the number of foreclosures. Reducing foreclosures allows investors to continue chipping away at the shadow inventory. Reducing the shadow inventory allows new buyers to focus on existing inventory of pre-owned and new construction instead of hoping for a distressed deal. Realigning buyers’ focus allows lenders to be more aggressive in their lending options based on historical housing performance not fueled by artificial stimulus.
In a market where new progress and new construction has been jumpstarted, a surge of foreclosures would potentially, AGAIN bring the market to an abrupt halt. For states like Illinois, where there are many properties still flooding the distressed and foreclosed markets due to the judicial process, the already backlogged court system, would simply be further overloaded.
On a separate note, this isn’t the outcome of the Act, as a few perks did result. By extending Act of 2007 as part of the American Taxpayer Relief Act of 2012, borrowers who have an adjusted gross income, AGI, of less than $100,000 can deduct 100% of their mortgage insurance premiums. If the borrower is above $100,000, they can still take advantage of the tax break but on a sliding scale.