Once again, the neck of the Mortgage Forgiveness Debt Relief Act (MFDRA) is in the guillotine. Senators Dean Heller of Nevada and Debbie Stabenow of Michigan intend to rescue the home foreclosure tax relief, advocating the creation of a bipartisan bill to extend the act’s protections through 2016.

This is the second time the MFDRA has come before Congress for an extension. The last extension in 2014 squeaked by to pass on December 31, 2014. The new extension is likely destined for the same fate – several months have already crawled by with no action from Congress for underwater homeowners – those exposed to short sales and foreclosures.

Another bill attempting to permanently exclude mortgage forgiveness debt from taxable income has been introduced, but the likelihood of either coming into effect is wishful thinking.

Is the MFDRA extension a big deal in California?

The effect of the MFDRA extension on California residents depends on whether a mortgage is a recourse or nonrecourse debt. California law determines purchase-assist debt secured by a one-to-four unit principal residence and discharged on a short sale (or foreclosure) is nonrecourse debt.

Discharge of indebtedness income due to the discount (short pay) on the short sale of a property encumbered by a nonrecourse debt is exempt from taxation as income under federal tax law. This protection is separate and unaffected by the outcome of the battle over another MFDRA extension. [26 Code of Federal Regulations §1.1001-2(a)(2), Internal Revenue Code §108(e), Calif. Code of Civil Procedure §580(e), Calif. Revenue & Tax Code §17144.5]

The MFDRA (and conforming state bills) would extend the protection for nonrecourse debt forgiveness to recourse debts forgiven through the end of 2014. The current state bill to extend this exemption is currently under consideration, pending budgetary review.

Most mortgaged California homeowners owe nonrecourse debt. Thus they are protected from taxation on discharge-of-indebtedness income on a short sale or foreclosure underbid regardless of the MFDRA and state bill extensions. [Calif. Rev & T C §17144.5]

However, a homeowner facing an underwater property encumbered with recourse debt needs to consider whether a short sale or a foreclosure will benefit them most.

Short sales require the homeowner with recourse debt to negotiate with the lender, who needs to agree to a discount if the sale is to close. The sale price of the home is less than the money owed to the lender, meaning the discount on the debt is still forgiven – a recourse debt which, without the special tax exemptions provided by the MFDRA, qualifies as taxable income.

Without the lender’s agreement to a short sale, a homeowner may still escape recourse debt by allowing the lender to initiate foreclosure of the property through a trustee’s sale. A trustee’s sale ultimately blocks the lender from obtaining a deficiency judgment for the remainder of the recourse debt. [CCP §580d]

However, homeowners who turn to strategic default by allowing lenders to foreclose through a trustee’s sale will take a hit to their credit score. Lower credit scores may raise interest rates homeowners must pay on future mortgages, or make it more difficult for homeowners to obtain mortgages in the first place.

Homeowners with recourse debt need to prepare their finances for the next few years in advance, then take a calculated hit to their credit scores and allow the property to go to foreclosure.

Taxable income without the MFDRA

Other states not sharing California’s tax exemption laws rely on the MFDRA’s protection. Without it, federal tax codes treat mortgage forgiveness discounts as taxable income. Thus, the option of a short sale without detrimental taxes is not available on discounts in those states. Taxes on mortgage forgiveness discounts may cost homeowners of properties encumbered with recourse debt tens of thousands of dollars in “income” they never personally received – though they did receive a home on the bet it would not fall in value below the mortgage which funded its acquisition.

Many homeowners who may have escaped heavy debt burdens through short sales and foreclosures opted to stay put for fear of incurring indomitable taxes.

The further we get from the housing crisis, the less likely it is Congress and the government will continue to subsidize forgiveness for recourse debt. If you still have clients in this situation, help them choose what to do sooner rather than later.

Re: “Mortgage debt forgiveness still a taxing issue for many short sellers,” from the Los Angeles Times