In a short sale a lender forgives a portion of a borrower’s debt by allowing a property tax relief to be sold at less than the amount owed by the borrower. Often times, as part of a short sale, the lender will then forgive the debt.
For example, if a borrower owes $1 million on a home mortgage but their house is only worth $900,000, the borrower is sometimes able to negotiate with the bank to accept a sale to a third party for $900,000 as payment in full on the borrower’s obligation. Ordinarily, if the lender accepts less than the full amount owed – $900,000 of $1 million in this example – then the borrower is taxed on the $100,000 debt forgiveness as ordinary income. This is the way it was before and after the Mortgage Forgiveness Debt Relief Act.
The Mortgage Forgiveness Debt Relief Act made it easier on borrowers because it allowed the lender to write off the forgiven debt without the borrower having the forgiven debt treated as ordinary income. In other words, in the example above, the borrower would not be taxed on the $100,000 of debt forgiveness.
The Mortgage Forgiveness Debt Relief Act expired. That means that we have gone back to a system where the $100,000 in the example will be taxed as ordinary income. The issue now is whether Congress will renew the act. In a rising real estate economy the need for short sales becomes less and less. It will be interesting to see what Congress does with this act. Doing nothing may be a sign that the economy has improved so much that this is no longer a widespread concern.