A substantial tax break offered to homeowners who have unpaid mortgage debt is set to expire at the end of the year. The tax break has been in effect since 2007 and was designed to help homeowners who are “underwater” no their loans, which means that they owe more than the house is worth. The tax break helped those who had to sell their house, modify their mortgage, or who lost the property to foreclosure.

Letting the tax break expire will mean higher tax liabilities for many middle class families who were already struggling to deal with inflated payments and a depleted property value. The tax break specifically excludes taxation on forgiven mortgage debt, which is otherwise treated as additional income for tax purposes. Mortgage debt is forgiven after a foreclosure or short sale and can amount to a few thousand dollars or a few hundred thousand dollars, depending on the circumstances.

To understand the implications of taxing forgiven mortgage debt as income, consider a family making $50,000 a year who lives in a home that they purchased for $250,000 before the housing crash. At that time the home may have been worth that amount of money, but today it is worth closer to $100,000. Even if the family has managed to stay current on most of their payments and made a healthy down payment, they likely have only managed to chip away at about $100,000 of that debt. This means that if the home goes into distress and is lost to foreclosure, the forgiven debt could be up to $150,000, counted as income. This would quadruple their effective income for the year and bump the family to a much higher marginal tax rate, about 28 percent instead of 15 percent. One can see how the tax bill can add up quickly and leave families with significant tax debt that they may be unable to pay. 

Source: Orlando Sentinel, “’Underwater’ homeowners likely to face new tax bill,” Mary Shanklin, Dec. 17, 2013.