Housing Recovery Could Relapse If We Go Off The Fiscal Cliff

If Congress does not find a solution before the end of the year to our looming “fiscal cliff” issue, we could see a massive relapse in the housing recovery.

There is a provision that erases taxes on selling a home for less than what is owed to the bank that will expire if we go off the ‘cliff’. The expiration of this provision would mean the end of short sales, which have greatly helped in the housing recovery.

The removal of this tax provision would be a major new headache for homeowners who owe mare than their house is currently worth. Right now, that number stands at one in four homeowners. Sellers who find themselves stuck in this situation would be forced to come up with a big check to the government to pay the tax on the difference.

Paul Diggle, a housing economist at Capital Economics was quoted as saying, “That would blow the housing recovery. The increased use of short sales, rather than foreclosures, has become an important support to the recovery.”

At this time, roughly 25% of all home sales in the United States are short sales. This is the situation we have been left with after roughly 12 million homeowners found themselves owing more than their homes are worth when the housing market collapsed.

When a short sale is made, the lender accepts the proceeds as payment in full. They then write off the remaining value of the loan. It has become a more efficient way for lenders to get bad loans off of their books. Consider it the foreclosure alternative.

This past week, Bank of America reported that 62,000 borrowers have completed short sales that have saved them $7.4 billion in debt. That is an average of $120,000 per borrower.

Before the housing crisis, forgiven mortgage debt was taxed to the borrower as ordinary income. Under those rules, the typical household who has received a settlement so far would be facing a tax bill of $19,000.

To combat this, in 2007, Congress passed the Mortgage Debt Relief Act. This protected the borrower from paying taxes on their forgiven debt. The law was extended in 2010, but is currently scheduled to expire at the end of 2012 unless Congress steers us clear of the “fiscal cliff”.

This law is credited with helping to get the housing market out of its worst recession since the 1930s. Although, we have not recovered to a pre-mortgage crisis level yet, the sales of both new and existing homes have been steadily rising. In many areas of the nation, housing prices have started to rise again.

If the law expires, more people may choose foreclosure when faced with the burden of a tax bill they can ill afford. Foreclosure has a much more negative impact on the neighborhood and home values than a short sale does.

For lenders, it is nothing but bad news too. On average banks make over $25,000 less on the sale of a bank-owned property than one transferred by short sale. They also avoid all the legal costs of taking a home and the costs of maintaining it until it is sold.

Hopefully, Congress acts quickly to extend this law and keep the housing market moving forward. If not, expect to see more foreclosures in your area, which is bad news for all of us.