Those who are considering a short sale may want to do it sooner rather than later. Unless a key law is extended by the end of the year, anyone who conducts a short sale after the end of 2012 may be subject to tax liabilities on the forgiven mortgage debt.
The Mortgage Forgiveness Debt Relief Act was passed in 2007. Normally forgiven debt is taxed as additional income. Under the act, mortgage debt that is forgiven (for instance in a short sale) is considered tax free up to $2 million per year. In 2008 the act was extended to last through 2012, but is unclear whether or not the the act will be extended again.
This is important for a number of reasons, but chief among them is that the newly agreed-upon mortgage settlement (which is a brutally bad deal for U.S. homeowners, taxpayers, and those who are fans of the rule of law in general) incentivizes banks to allow more short sales. Any benefit from the increased willingness of banks to commit to short sales could be wiped out if taxes start to be levied upon forgiven debt.
Another problem with the expiration of this act is that short sales tend to take an exceedingly long time to complete. In order to conduct a short sale, a homeowner must find a buyer and get the lender’s permission to sell the house for less than is owed on the mortgage. Between getting permission and getting financing, the whole process can take many months (take a look at this comment thread on Trulia’s website to get a sense of how long short sales can take). It is entirely possible that many people could start the short sale process in the coming months but not see the sale completed until 2013. These people could end up with sizeable tax bills.
It stands to reason that many, if not most of the people short selling their homes are in some degree of financial duress. Adding more debt to their burden adds insult to injury, and is not going to help anyone.
Short sales serve an important market-clearing function. In order to get the housing sector off life support, we must address the more than $700 billion in negative equity that is preventing recovery. Short sales are only a piece of this effort, and they are important nonetheless. Congress needs to act now to extend the Mortgage Forgiveness Debt Act in order to promote short sales and help the housing market heal.