NO MERCY: The End of Tax-Free Mortgage Debt Forgiveness?

A recent online article brings to light some turbulence that may be ahead for homeowners who are underwater on their homes:

\
The Mortgage Debt Relief Act of 2007 is scheduled to expire at the end of the year. The legislation allows borrowers to avoid paying income taxes on the amount of principal that is being forgiven as part of a loan modification or a short sale. If the law expires, homeowners will have to pay taxes on the debt reduction.

Consider: an individual buys a home for $150,000. The economy tanks, he loses his job and faces foreclosure. He manages a short sale of the home for $80,000. Unless the law is extended, he would be taxed on the $70,000 debt that is being forgiven, as if the value that doesn't exist were personal income.

The tax also would be imposed if the bank modified the loan, reducing the principal so that the homeowner could better manage payments.

Obviously, the expiration of this law is bad news for folks who are considering doing a short sale.  I remember working with homeowners on short sales prior to this law.  At that time, it was up to the particular bank whether they issued a 1099 to the owner or not for the debt forgiven in the short sale.  The whole premise of a short sale is the lack of money available by the owner.  Having the IRS tax that owner for "phantom" income is bad policy and simply ads insult to injury.  Let's hope that this law is not allowed to expire.