Although most real estate markets have rebounded from their recession lows, this harsh fact remains: About 7 million homeowners continue to be stuck in the tar pit of serious negative equity, with mortgage debt at least 25% higher than the value of their property, according to research firm RealtyTrac.
Many of these owners are also hurting financially. They are behind on mortgage payments, often in negotiations with their lenders on ways to modify their loan terms, write off a portion of their debt or do a short sale — selling the house for less than the mortgage amount owed to a new buyer, with the lender forgiving the unpaid balance. Improvements in housing prices have largely bypassed these folks, as has the overall economic recovery in the last several years.
All of which underlines the significance of a legislative effort now getting underway in Congress to spare these people from punitive federal taxes on any amounts forgiven.
Wait a minute, you might ask: Didn't Congress extend the Mortgage Forgiveness Debt Relief Act last year, which was designed to ease the burden on troubled owners with negative equity? Yes, it did — but only for people who received write-offs during 2014.
The debt forgiveness law expired at the end of December and is now dead. Owners who are currently negotiating or planning loan modifications or short sales involving cancellation of portions of what they owe in 2015 have no legal protection against big tax bills next year.
Under the federal tax code, if a lender forgives mortgage debt as part of a loan modification or other arrangement, that amount will be treated by the IRS as ordinary income and taxed accordingly. Typically the tax bill runs into the tens of thousands of dollars.
(Note to California homeowners: If your mortgage forgiveness occurred because of a short sale, you're exempt from the tax because of an IRS interpretation of state law.)
Two senators — Nevada Republican Dean Heller and Michigan Democrat Debbie Stabenow — have introduced a bipartisan bill that would extend the mortgage debt relief safe harbor for eligible homeowners through the end of 2016. Heller is a member of the tax-writing Senate Finance Committee and is in a strategic position to attach the bill to a larger piece of legislation that is moving through his committee — something he pledged to do.
Both Heller and Stabenow represent areas that were hit hard during the housing bust and still have significant numbers of underwater and financially distressed owners.
In Nevada, 30% of Las Vegas housing units with mortgages are seriously underwater, according to RealtyTrac researchers. In Michigan, 24% of metropolitan Detroit houses with mortgages are in the same position. In Las Vegas, 60% of all seriously underwater homes are also classified as financially distressed at some stage of the foreclosure process. In Detroit it's 47%.
Negative equity is a national problem — from Rhode Island and portions of Maryland to Arizona and non-coastal California — which is one reason Heller and Stabenow hope to gain supporters this session from colleagues representing other states.
In Florida, for example, four metropolitan areas rank among the highest with negative equity levels nationwide. In Tampa, 52% of severely underwater properties were also financially distressed. In Miami, it's 46%. Other large metropolitan markets with unusually high levels of negative equity combined with financial distress include Chicago (48%) and Cleveland (45%).
But what about people who got in under the wire and completed mortgage debt forgiveness deals with lenders last year? How should they proceed now that the filing deadline for 2014 federal tax returns is just weeks away?
The IRS recently published a special bulletin with the following tips:
•Keep in mind that not all real estate qualifies for the debt cancellation tax exclusion. To be eligible, the property must be your "main home," the principal residence you occupy most of the year. So if you did a short sale on a Miami Beach condo that you use during the winter months but you live elsewhere for the rest of the year, it doesn't qualify. Ditto for rental properties and real estate you use primarily for business purposes.
•Your lender is required to report debt cancellations (over $600) to the IRS and should already have sent you a Form 1099-C showing the amount forgiven. If you haven't received the form, or you disagree on how much debt was written off, get in touch with the lender. Pronto.