Among the various options offered to help distressed homeowners deal with collapsing mortgages and the resulting loss of houses and credit, the Mortgage Forgiveness Debt Relief Act is a little known break, freeing homeowners from a tax liability on mortgage debt forgiven by a lender. Unless extended by Congress, the Act expires at the end of 2012, likely triggering a rush of short sales and bankruptcy proceedings as homeowners try to sidestep the liability – and putting more low-cost homes on the market for purchase by income property investors.

The Mortgage Forgiveness Debt Relief Act was created in 2007 to help struggling homeowners. When a homeowner defaults on a mortgage, the house may be sold in a short sale, in which the property sells for less than the mortgage is worth. The difference between those prices can be forgiven by the lender. Likewise, if the situation is not resolved and the house goes all the way into foreclosure, the lender collects all proceeds from the sale, and the difference between< this amount and the amount owed is typically forgiven.

The Mortgage Forgiveness Debt Relief Act frees homeowners in these situations from paying income tax on the portion of the mortgage debt that is forgiven. Under the terms of the Act, if a mortgage is worth $150,000, but the home sells for $100.000 at a foreclosure auction, the $50,000 difference is forgiven and the homeowner is off the hook. But if the Act dies at the end of 2012, that $50,000 could be taxed by the IRS, placing yet another burden on the homeowners in crisis.

Not all homeowners will be hit with taxes, though. If the debt is discharged in bankruptcy, no tax needs to be paid, and if a homeowner is insolvent, having more debts than assets at the time the mortgage debt was forgiven, no tax penalty is charged. But for most homeowners with an investment in their home, the demise of the Act is a cause for concern.

Although foreclosures have declined since the high point of the mortgage crisis a few years ago, short sales, as we’ve mentioned before, have tripled, reaching about half a million transactions per year. With expanded hardship criteria, more and more struggling homeowners are choosing this option to avoid foreclosure and try to repair their credit. With the possible demise of the Debt Relief Act, many distressed homeowners are rushing to complete short sales by the end of the year in order to avoid the potential tax hit looming in 2013.

Financial analysts fear that the exemption won’t be extended, which creates more pressure on homeowners already in trouble and raises the specter of more uncertainty in a housing market struggling to rebuild from the last homeowner crisis. For individual investors working with Jason Hartman’s investing principles, though, the rush to complete short sales while the Mortgage Forgiveness Debt Relief Act still applies can mean new opportunities as more low-cost properties hit the market in the next few weeks. (Top image: Flickr | flickr-rickr)

The American Monetary Association Team