There has been and will continue to be much talk about the impending "tax cliff" that we will all go over come January 1, 2013, unless Congress takes preventative action. Two things are referred to: (1) the so-called Bush tax cuts are set to expire at the end of the year; (2) automatic spending cuts of over $100 billion, required by the Budget Control Act, will take effect. If these things happen, according to the non-partisan Congressional Budget Office, the economy will contract by 1.3% in the first half of the year and we will be back in recession.
This is big stuff with big consequences and we have to hope that somehow, probably not until after the elections, Congress will manage to focus on these issues and come to a satisfactory resolution.
Regrettably, though, while these big issues have been and will be getting a lot of attention, not much is being said about another tax issue that could seriously upset the still-fragile real estate market. The Mortgage Forgiveness Debt Relief Act of 2007 (the Act), which was extended by the Emergency Economic Stabilization Act of 2008, is also set to expire at the end of this year. It is entirely separate from the Bush tax cuts and its expiration would not be affected by their extension.
There are probably more than a few people who don’t remember or never knew what was accomplished by the Act. Almost 1/4 of the current Realtor® population was not even in the business prior to the time it took effect. They have not known a market without it.
It all has to do with what has often been called "phantom income." Phantom income is a term that applies to debt forgiveness. Debt forgiveness, of course, is the very essence of short sales. You can short sell your house for a fair market value of $200,000, even though you have a $250,000 mortgage, because (if) the bank cancels (forgives) the debt. That $50,000 of cancelled debt is "phantom income" (you never got to lay your hands on it), and, in the eyes of the IRS, it is generally taxable. (There is not room here to discuss why the taxation of phantom income is sensible tax policy, but, in my view at least, it is.)
Most Realtors® know by now that cancelled debt in a short sale is not taxable when (1) the property sold is the taxpayer’s principal residence, and (2) the debt is Qualified Principal Residence Indebtedness (a loan secured by the residence used to acquire, construct, or substantially improve the residence).
That exception to the general rule that phantom income is taxable is the result of the Act referred to earlier. Unless the Act is extended, the exception will no longer apply.
These days in many markets, short sales represent 1/4 - 1/2 of all transactions. If the Act is allowed to expire, it can reasonably be expected that the volume of short sales would be greatly diminished. Why? Because the prospect of being taxed on (the amount of) cancelled debt provides a powerful disincentive to engage in a short sale.
In the past few years the administration, the Congress, state legislatures, and even regulatory institutions have undergone all sorts of efforts to make short sales easier. (Their success in doing so is another issue.) That makes it all the more ironic that so little attention has been paid to extending the Act. A couple of bills have been submitted (Rangel, HR 4202, a two-year extension; Reed, HR 4336, a one-year extension), but they are just sitting in committee. Extension of the Act is on NAR’s legislative agenda. One hopes that will translate into overt action.
It would be a shame for this important legislation to expire just because it got lost in all the attention being paid to the big issues.