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What happens if the debt forgiveness in a short sale becomes ordinary income?
If the difference between the short sale price and the amount that is owed on the mortgage ever became ordinary income for the already strapped homeowner, short sale activity will grind to a halt. This is a scenario that could potentially occur if current tax law is not extended!
This choice by homeowners to avoid a potential transaction that would help to clear the market of inventory would also occur if and when deeds-in-lieu, foreclosures on recourse loans and principal reductions are treated in the same manner.
This fact is evidenced in the chart below which shows what has happened to short sale activity as a result of the expiration of the Mortgage Forgiveness Debt Relief Act as of December 31, 2013 (short sale activity had already dropped the prior two years due in part to the rise in home prices that pulled some mortgages back above water).
This Act was originally passed in 2007 at a time when homeowners looking at the prospect of foreclosure during the financial crisis faced a double whammy if instead they went the short sale route or one of the other strategies mentioned before.
Prior to this legislation being enacted if a homeowner owed $300,000 on their mortgage and agreed to a short sale price of $250,000, the $50,000 difference would be considered as income and a taxable event.
As anyone could imagine this fact was a strong disincentive for anyone to engage in this type of transaction.
The Mortgage Forgiveness Debt Relief Act removed this obstacle and the result was that the pace of transactions grew strongly.
But the uncertainty caused since the beginning of the year concerning taxability has caused a slowdown.
While it is expected that Congress will retro-actively extend this Act, there are no guarantees and certainty is what homeowners need to proceed.
Congress will hopefully pass the extension in the near future so that the housing market can continue to heal!
Chart courtesy of CoreLogic
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