Mortgage borrowers who lose their homes to foreclosure or face financial difficulties due to being underwater on their loan could face another hit in 2014 - a big tax bill.

A law shielding homeowners against the tax consequences of mortgage debt that was erased through a loan modification, foreclosure or other means expires after Dec. 31. Congress has pretty much wrapped up work for the year and is highly unlikely to renew it by year's end.

The Mortgage Forgiveness Debt Relief Act was originally passed in 2007 to shield borrowers who'd already suffered a financial blow from taking another hit on their taxes. Congress gave it a one-year renewal for 2013, but efforts to renew it again have stalled out in recent weeks.

Fixes tax oddity

The law was intended to address a quirk in the tax code - that debt that has been wiped off the books is counted as income for tax purposes. While that makes some sense from an accounting perspective, particularly when involving persons with sophisticated finances, it creates an additional burden for someone who has been through foreclosure or needed a loan modification to keep their mortgage payments affordable.

Without the debt relief act, a person who lost their home through foreclosure or a short sale could end up owing taxes on whatever the unpaid balance of their mortgage was, since it was a debt they no longer had to pay. In practical terms, the IRS rarely tried to collect in such situations, since the homeowner had also forfeited a major asset by losing the home.

Things get a bit stickier in the case of a loan modification where part of a borrower's mortgage debt is forgiven, however. In that case, the amount of debt that is written off could easily be construed as income, as it provided a direct financial benefit to the borrower and helped them acquire a valuable asset.

However, the whole reason for giving such borrowers a loan modification in the first place is that they are in considerable financial distress, so that hitting them with a major tax bill simply undermines the whole purpose of granting a loan modification in the first place.

Could put brakes on loan mods

Though the worst of the housing crisis passed several years ago, lenders continue to process a substantial number of loan modifications, short sales and other foreclosure-avoidance remedies as part of the terms of settlements reached with the federal and state governments over improper foreclosure and mortgage servicing practices.

It's quite possible that Congress will vote to extend the Debt Relief Act after they return in the new year and make the action retroactive to Jan. 1. However, until they do so it appears that loan modifications and short sales may be put on hold pending extension of the bill.

Renewal of the legislation is reportedly being held up by Rep. David Camp (R-Mich.), chair of the tax-writing Ways and Means Committee, who is said to favor allowing all temporary tax provisions to expire in order to gain leverage for more extensive changes to tax policy next year. In that event, it could be some time before a vote is taken to renew the exemption, if it happens at all.

Published on December 26, 2013