What does the Fiscal Cliff mean for Short Sales?

By now, we’ve all heard of the looming “fiscal cliff” that awaits us if Congress doesn’t come to an agreement on tax legislation by the end of 2012.  There are several tax laws that must be extended, modified, or allowed to expire, but one is of particular importance to the real estate industry.

The Mortgage Forgiveness Debt Relief Act of 2007 (which has already been discussed at length on this site), is set to expire at the end of 2012.  

Let’s take a brief look at why this is important to the real estate market, and particularly short sales.  Nationally, short sales account for roughly a quarter of home sales, and they have been a huge factor in the fragile housing market recovery.

In a short sale (and in most foreclosures), the property is sold at a price less than the amount owed on the mortgage.  This results in a deficiency balance, which is typically “forgiven” by the lender.  One key reason that banks will do this is explained by John Schoen at NBC News:

The five biggest mortgage lenders also got a powerful incentive to forgive more mortgage debt following a $25 billion settlement in April with 49 states and the federal government. Under a complex formula, the lenders earn credits against a portion of the settlement payment for each dollar of mortgage debt forgiven.

Sounds good, right?  Well, not when that forgiven amount results in taxable income in the eyes of the Internal Revenue Service.  After all, what good is it for a borrower to sell their home in a short sale if they end up having a huge tax bill?

According to Schoen, from March 1 until June 30 of this year, the average short sale resulted in $77,000 in debt relief.  This would usually result in about $19,000 owed to the IRS.

If Congress doesn’t act to extend the law, homeowners will have significantly less motivation to complete a short sale, resulting in more foreclosures.  Because foreclosures typically sell for less money, neighborhood values will drop and real estate prices could go back into decline.

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