Homeowners whose mortgage debt is reduced through a loan modification or short sale could get hit with a tax bill if Congress doesn't act to extend a special exemption due to expire at the end of the year.

The Mortgage Debt Forgiveness Act of 2007 was one of the first measures enacted to provide homeowner relief as foreclosures rose and the housing market began to show signs of unraveling. It exempts from taxation any mortgage debt that is wiped out as the result of a loan modification or short sale.

Canceled debt usually taxable

Under normal circumstances, canceled debt is treated as income for tax purposes. But with signs of a growing housing crisis building, the Bush administration and Congress worked together to pass the law exempting forgiven mortgage debt from taxation, at least temporarily.

Now that law is due to expire at the end of this year. An extension appears to have bipartisan support. But with Congress focused on hammering out a new debt deal before a new debt limit is reached in early February - and the prospect of another government shutdown - it's not clear whether even a politically popular measure can get through.

While Congress could extend the law retroactively - the debt standoff could run as late as March or April before the government truly runs out of financing options - failing to extend it might deter homeowners who were considering a short sale or loan modification from pursuing those options.

The Act allows taxpayers to exclude up to $2 million in forgiven mortgage debt on a principal residence from tax considerations ($1 million married persons filing separately). Second homes and investment properties are not eligible.

Published on December 3, 2013