Econintersect: Consider a couple that scraped together all the cash they could muster in early 2006 to buy their dream home in one of the frothy real estate 
markets. Let’s say they were able to come up with $40,000 and got the $340,000 home with a $300,000 mortgage. Now they are both out of work, or at least full-time work and so have very limited income, and their home is worth only half of what they paid. But they are lucky in one regard: they have an offer from a buyer that will net them $170,000. The problem, of course, is that they owe the bank $290,000 to repay the outstanding mortgage balance.
If they cannot arrange a short sale with the lender they can only sell the house if they bring $120,000 to the closing. And they have trouble just buying groceries and paying for utilities on their meager income. They haven’t even been able to make mortgage payments for over a year. There are no savings – they all went to make a down payment of the house.
But they are lucky a second time. The bank agrees to settle the mortgage for $170,000 in what is known as a short sale.
This is a common practice when the lender feels that the $170,000 cash in hand will be better either of the two alternatives: (1) leaving the defaulting borrower in a house they cannot afford to maintain; or (2) foreclosing on the mortgagor and then having an unoccupied REO (real estate owned) house on their hands.
In normal situations existing before the Great Financial Crisis the mortgagor would be subject to ordinary income tax on the forgiven debt, in this case $120,000. Since they have little income only part of the $120,000 might be taxable. If their income is around $15,000 it will be nearly fully offset by the standard deduction and personal exemptions. Then the full $120,000 would be subject to the progressive tax brackets and the bill would be around $23,500 by Econintersect reckoning.
Going over the fiscal cliff would have allowed a temporary provision in the federal tax code that exempted home short sales starting in 2007 from the tax liability for the imputed income from the cancelled mortgage debt.
Buried in the financial cliff legislation was the extension of the exemption for another year. Our hypothetical couple will not receive a tax bill.
Sources:
- Tax Break for Forgiven Mortgage Debt Extended (Drew Harwell, Tampa Bay Times, 03 January 2013)
- Mortgage Debt Tax Relief Extended (Realtor Mag, 04 January 2013)
- Updated: 2013 Federal Income Tax Brackets And Marginal Rates (Luke Landes, Forbes, 05 January 2013)
- CCH projects 2013 standard deductions, exemptions, tax rates (Wolters Kluwer, 17 September 2012)
