With all of the talk surrounding the uncertainty of the fiscal cliff and the estate tax, there is another federal tax law that is set to expire at the end of 2012 and for which there appears to be no political solution. That problem is the tax on the forgiveness of debt which affects homeowners in the event of foreclosure or short sale who now are protected from paying taxes on the forgiven debt. However, the law that provides that protection is set to expire at the end of 2012.
First, a bit of background. As a general rule, debt that is forgiven is considered “cancellation of debt income” under Internal Revenue Code (“IRC”) Section 61(a)(12) unless an exception applies such as if the debtor is insolvent (IRC Section 108) and, at least for now, a special exception that comes from the Mortgage Forgiveness Debt Relief Act of 2007 (the “Act”). As the fiscal crises began to take hold in 2007, homeowners began to default in large numbers and, when they did, the owner of the mortgage often took a loss on the sale of the home after foreclosure. The amount of that loss was considered forgiven debt which was, in turn, considered to be cancellation of debt income. So, not only did people lose their homes, they also were hit with a large tax bill for the cancellation of debt income.
The Act added an exception to cancellation of debt income resulting from foreclosure beginning in December 2007 and was originally intended to last for three years (for cancellation of debt income through 2009). President Obama’s stimulus bill in 2008 extended the relief through 2012 but the road ends there. Now, unless the federal government takes action before the end of the year (which, at this point is very unlikely), the cancellation of debt income problem for foreclosures will be back again. This article in CNN Money argues, I think correctly, that a failure to fix the problem could extend the housing problem because it will act as a disincentive for homeowners to cooperate with the foreclosure process, delaying the inevitable and extending the problem