Foreclosures have been dropping dramatically over the past year, but without help from Congress they could begin to rise again. In 2007, Congress passed a tax exemption for mortgage debt forgiveness. That exemption expired at the end of 2013 and has not been extended, as some predicted it would be.
"There is no question that eliminating the tax break is a big blow to short sales and principal forgiveness and will make those forms of mortgage borrower assistance/relief a lot less attractive," said Guy Cecala, publisher of Inside Mortgage Finance.
The recent foreclosure crisis was one of the most dire episodes in U.S. housing history, but it could have been even worse had the banks not forgiven billions of dollars in mortgage debt. Much of that was mandated by legal settlements with the federal government and state attorneys general. Since 2007, banks have approved approximately 2.8 million short sales, according to Black Knight Financial Services. A short sale is when the home is sold for less than the amount of the mortgage.
There is support in Congress for an extension, as well as among state attorneys general and housing advocates. Several bills are being considered that could extend the tax relief through 2015 or 2016, but with the much broader move to overhaul the entire tax code, they appear to be getting lost in the shuffle.
It is difficult to put an exact number on principal reduction mortgage modifications, but they number in the millions as well. All together, billions of dollars were expunged on paper and not taxed as income, as they would have been prior to 2007. These foreclosure alternatives helped and continue to help bring down the number of homes being lost today.
Loans in the foreclosures process are down nearly 28 percent from a year ago, according to Black Knight, but the pipeline, while no longer growing, is still large. More than 3 million borrowers are behind on their mortgage payments, and 1.24 million are in the foreclosure process. Many of those delinquent borrowers could avoid foreclosure through a short sale or principal reduction loan modification.
At her real estate office in Chicago, Marki Lemons offers seminars to educate troubled borrowers on their options, options that she says are suddenly shrinking.
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"All it's going to do is prolong recovery, and so we know these people can't afford these houses, they have to prove financial hardship, so if they don't have the money to keep a roof over their head, how are they going to be able to pay the IRS?" she asked.
Tony Janega, who attended her seminar, has been working on a short sale for three years. It was finally approved last week, about five weeks too late to qualify for the tax exemption. His home sold for $125,000 less than the amount he owed on the mortgage. Depending on his tax rate, he could owe Uncle Sam about $30,000. That is money he does not have.
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"I'm nervous, I'll be honest with you. There have been some long nights these last three years, just having to figure out what's going to happen, and now if this debt relief act isn't extended, I'm really nervous now. I've stayed up late at night—I can't sleep at night, it's been a lot of stress," said Janega.
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Even banks and investors could get hurt if borrowers can no longer afford short sales. Short sales have helped to clear much of the distress from the housing market, especially in states where the foreclosure process requires a judge. Those states have huge backlogs of delinquent loans.
"With fewer short sales, you're going to see longer liquidation timelines, so you're going to see more full foreclosures and REOs [bank repossessions]," said Sean Nelson of Fitch Ratings. "With longer timelines, you have more costs associated with liquidation of the properties. More costs translates to lower recoveries for investors.