RealEstateEconomyWatch.com

In three months, short sales may screech to a halt unless legislation is extended that allows sellers to avoid paying taxes on the amount of their mortgages that lenders forgive when then sell their homes.

Since 2007, when Congress passed the Mortgage Forgiveness Debt Relief Act, the sellers have not had to pay income taxes on the value of the loss incurred by their lenders, which previously was considered income. Debt reduced through mortgage modifications as well as mortgage debt forgiven in a short sale qualifies for the relief. Normally, debt that is forgiven or cancelled by a lender must be included as income on the homeowner’s tax return and is taxable.

In order to qualify for the tax break, the cancelled debt must be used to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes. In addition, the debt must be secured by the home. The maximum amount that can be forgiven tax free is $1 million per taxpayer.

Short sellers could face huge tax bills for transactions that close after January 1. If a borrower’s mortgage balance is $350,000 and his bank approves a short sale for $300,000, that $50,000 difference would be considered taxable income. For a homeowner earning $100,000 a year, their tax liability would increase 50 percent.

Several states, including California, ;have passed laws excluding debts forgive by modifications and short sales from state income taxes that would be owed by homeowners on short sales or modifications.

Loss of the tax break will encourage defaulting owners to choose a strategic foreclosure rather than increase their tax liability by seeking a modification or selling short. In recent years short sales have become nearly as prevalent as foreclosures as lenders have realized they lose less money with short sales and foreclosure processing time has grown to a year or more in some states. Short sales accounted for more than 30,700 home sales through May compared to 54,000 foreclosures, according to CoreLogic.

The tax forgiveness legislation has also encouraged owners to seek mortgage modifications that may result in the reduction of principal. Forgiveness of principle also creates a tax liability which the expiring law has eliminated for the past five years. Some 5.9 million total homeowners have received mortgage modifications either through federal or private sector lender initiatives since April, 2009, though not all received principal reductions.

With just three months to act, the real estate lobby in Washington is scrambling. Legislation introduced by Senator Debbie Stabenow of Michigan would extend tax relief through 2013, while a House bill sponsored by Representative Tom Reed of New York would extend the relief a year. Another bill sponsored by Representative Charles Rangel, also of New York, would extend it two more years.