NEW YORK – Feb 6, 2014 – According to Fitch Ratings, the recently expired tax relief provided by the Mortgage Forgiveness Debt Relief Act (MFDRA) of 2007 may lead to modestly negative pressure on liquidation timelines as potential short sellers hold off listing their home. The longer it takes for Congress to renew the tax forgiveness – assuming it does – the more home sales will be impacted.
The tax relief expired Jan. 1, 2014, creating larger tax burdens for underwater borrowers who receive some form of mortgage debt forgiveness. Without tax forgiveness, the IRS considers any capital forgiven by a lender in a short sale or foreclosure to be income to the homeowner, and it taxes it accordingly. The MFDRA provided tax relief by allowing certain borrowers to exclude such income on their tax returns. The act applied only to debt associated with a primary residence, and no more than $2 million of debt could be excluded per year.
Without the tax break renewal, Fitch expects declines in short sale volume, fewer principal forgiveness modifications and higher re-default rates on those that are granted.
The MFDRA was originally signed into law in December 2007 and Congress is currently considering several bills that would extend the tax relief through 2015 or 2016. The extension has broad support from state attorneys general, and most housing and consumer advocacy groups. However, the passage of an extension bill by Congress is not a given, and at present the tax breaks remain expired.
Congress could renew the tax forgiveness and make it retroactive, meaning any short sales that occurred after Jan. 1, 2014, would be covered. But even the retroactive aspect isn’t a sure thing.
Without the assurance of a tax exemption on forgiven debt, there is less incentive for distressed borrowers to agree to a voluntary property sale that will not pay the loan off in full. This, in turn, will likely increase the number of involuntary foreclosure sales, Fitch says.
The MFDRA’s expiration also gives servicers less incentive to offer principal forgiveness modifications since the tax burden on the borrower increases the likelihood of re-default. Servicers may increasingly opt instead for principal forbearance, which requires the borrower to repay the reduced principal amount at the end of the loan term.
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