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Foreclosures Could Spike With Fiscal Cliff

NEW YORK ( TheStreet) -- Short sales, increasingly the preferred route for borrowers behind on their mortgage to discharge their debt, might decline if the Mortgage Forgiveness Debt Relief Act of 2007 is allowed to expire at the end of the year.

In a short sale a borrower enters into an agreement with the bank to sell the property to a third party for an amount less than the debt owed. Banks forgive the difference between the sales proceeds and the debt owned, essentially they get shorted on the debt.

Cancelled debt is considered income and is taxable, but under the 2007 Act, debt forgiven in connection with a mortgage modification or foreclosure is exempt from tax.

The Act is scheduled to expire end of 2012. There is a bipartisan push to extend the relief, but it remains on the table in the fiscal cliff discussions, along with the mortgage interest deduction.

The expiration of the Act could "stifle the trend towards short sales," according to Daren Blomquist, vice president at RealtyTrac.

"Homeowners who agree to a short sale could see their income tax jump significantly because the portion of the unpaid loan balance not covered by the short sale proceeds will be considered taxable income in many cases," said Blomquist. "The prospect of being taxed on potentially tens or hundreds of thousands of dollars in additional income may motivate more distressed homeowners to forgo a short sale and allow the home to be foreclosed."

Short sales accounted for 22% of all residential sales in the third quarter, according to RealtyTrac. Meanwhile, sales of homes at various stages of foreclosure accounted for 19%. Preforeclosure sales- sale of properties in some stage of foreclosure-now outnumber the sales of foreclosed, bank-owned properties.

Short sales have been seen as the best solution for both borrowers and banks, especially given the lengthy foreclosure process in most states.

Banks have also executed more short sales under the national mortgage settlement. In fact, of the $26.1 billion in mortgage relief that the big banks- Bank of America (BAC - Get Report), JPMorgan Chase (JPM - Get Report), Wells Fargo (WFC - Get Report), Citigroup (C - Get Report) and Ally Financial -have extended, more than half comes from short sales.

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