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Home Short-Sellers Could Face a Huge Hidden Tax

BOSTON (TheStreet) -- Down-on-their-luck homeowners who avoid foreclosure through short sales or loan forgiveness could owe the IRS big bucks because partisan wrangling is holding up extension of a popular tax break designed to help them.

"We're talking about people who are financially distressed and simply don't have the wherewithal to pay this tax liability," says Steve Brown, president of the National Association of Realtors. "If they had the money, they wouldn't be in distress."

Before 2007, homeowners who worked something out with their lenders to avoid foreclosure would find suddenly that the Internal Revenue Service treated any principal a bank forgave as taxable.

Say you owed $400,000 on a home whose value had dropped to $300,000 because of the housing bust, but you couldn't afford to either keep up the mortgage payments or sell the place and make up the $100,000 shortfall.

If you got the bank to agree to a "deed in lieu of foreclosure" taking back the house and forgoing the remaining $100,000 the IRS would consider the unpaid principal as "income" on which you owed taxes. You'd owe potentially as much as $30,000 or more on the money (and possibly state income taxes as well) even though you were probably broke.

Also see: 5 Cities That Aren't Seeing a Housing Recovery

Taxes also applied if you got a "principal reduction," in which you stayed in the home and the bank agreed to reduce your loan balance because it's not worth foreclosing, or if you did a "short sale" in which you sell your home at market prices and give the bank all proceeds, with the lender forgiving any amount over the sale price.

Congress passed a law seven years ago with bipartisan support to temporarily waive these taxes, but the measure expired Dec. 31 despite backing on both sides of the aisle for its continuance.

The Senate Finance Committee endorsed the measure as part of a package to extend some 50 tax breaks that expired at year's end. But Republicans are blocking a full Senate vote unless they can add a proposal to repeal a 2.3% medical-device tax that took effect as part of the "Obamacare" act.

Senate Majority Leader Harry Reid (D-Nev.) has countered by refusing to allow any amendments to the measure, apparently so Democrats facing re-election in states where Obamacare is unpopular can avoid voting on the medical-device tax. The measure is also bogged down in the House.

Democrats and Republicans blame each other for the gridlock.

"Congress needs to stop playing political games and act to help millions of families," says Democratic Sen. Debbie Stabenow of foreclosure-wracked Michigan, who co-sponsored the tax break's proposed extension with Republican Sen. Dean Heller of Nevada, another state hard hit by foreclosures.

Also see: Why We're Building Our McMansions Even Bigger

But Don Stewart, spokesman for Senate Minority Leader Sen. Mitch McConnell (R-Ky.), faults Reid for the tax break's demise.

"Sen. Reid allowed no amendments," Stewart says. "That was his decision."

The NAR sees the tax break's expiration as especially bad news for short sales, which Realtors consider crucial to helping the still-shaky housing sector recover.

"A short sale is far better for the market than a foreclosure, because generally speaking there's some level of maintenance to the property that falls off if the home goes into foreclosure," says NAR President Brown, who's also an Ohio real-estate broker.

He expects Congress to renew the tax break retroactively after Election Day, but says there's no guarantee that will happen and that the housing sector will suffer in the meantime. The NAR recently lowered its projection for 2014 short sales to 200,000 homes from 330,000 in part due to the tax break's termination.

"Getting a bank to approve a short sale is already a very difficult process," Brown says. "We think the fact that [short-sellers] could now also face a significant tax liability is enough to give any well-informed home seller pause."

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