Housing Alert: Short Sales May Be in Big Trouble

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As lenders plow through a backlog of over five million delinquent mortgages, short sales are becoming an ever more popular escape route. A short sale is when the bank allows a home to be sold for less than the value of the mortgage. The bank takes the loss, but that loss is generally less than a more costly foreclosure.

The government has been pushing more short sales at Fannie Mae and Freddie Mac through financial incentives, and banks are streamlining the process. Short sales have been gaining so much steam, they actually surpassed sales of foreclosed properties last spring, according to LPS Applied Analytics’ Home Price Index. But all the progress that has been made could end abruptly.

A short sale is debt forgiveness. Debt forgiveness is taxable. In order to help the huge volume of troubled borrowers and promote more short sales, Congress in 2007 passed the “Mortgage Forgiveness Debt Relief Act and Debt Cancellation.” The debt forgiveness from a short sale or a mortgage principal reduction would no longer be taxable. That act is part of many Bush era tax cuts that expire at the end of this year. Without an extension, short sales would grind to a halt, as might mortgage modifications that involve principal reduction.

“Realtors believe if the legislation is not extended, households who are already struggling to pay their mortgages will be further burdened with tens of thousands of dollars in additional taxes that they probably can’t afford to pay because the IRS would count the cancelled debt as income,” said Jamie Gregory, a lobbyist for the National Association of Realtors. (Read More:After Brisk Summer, Pending Home Sales Drop in August)

Short sales and mortgage principal reduction are the foundation of the $25 billion mortgage servicing settlement signed early this year by the nation’s largest lenders and state attorneys general. As of the end of August, first lien principal reduction trial modifications were offered and begun for about 28,000 homeowners, totally approximately $3 billion of potential relief, according to the settlement monitor, Joseph A. Smith. Banks have granted $10.6 billion in consumer relief, which would include short sales. More than a quarter of a million short sales were completed in the first half of 2012, according to RealtyTrac.

So what is the possibility of congress extending the tax relief? One Hill-watcher puts it at 60-40. The Senate Finance Committee passed a package of tax extenders right before the recess, including a one year mortgage relief extension, but leadership in the House of Representatives has not figured out how it wants to handle these extenders. With the looming “fiscal cliff,” tax cuts are an increasingly tough sell. This particular extension does have bipartisan support, but that doesn’t always mean passage in Congress, especially around a presidential election.

“It could be an uphill fight to get this passed this fall, as it will likely get caught up in larger debate of over taxes, deficits and the financial cliff. But we believe that it is a helpful provision for distressed borrowers, as getting a tax bill on forgiven debt can be another punch in the gut for families who are already facing financial hardship,” says David Stevens, president and CEO of the Mortgage Bankers Association. (Read More:Is Housing Risen From Ashes? 'Industry Has Come Back')

Rep. Jim McDermott (D-WA), who introduced legislation last March to extend the tax relief for three years said in a release, “Collecting federal income tax on relief intended for struggling homeowners is not only bad policy, but is simply wrong.”

With great uncertainty as to the fate of the tax relief, some say short sales could get a boost this fall. Borrowers and banks alike may rush to get in before the expiration, which could help boost overall home sales numbers.

Sector Watch: US Home Builders

—Toll Brothers

—DR Horton

—Hovnanian Enterprises


—Ryland Group

—Lennar Corp

—Beazer Homes USA

—Meritage Homes

—KB Home

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