The December 31, 2013 expiration of the Mortgage Debt Relief Act continues to plague underwater homeowners hoping to sell their houses.  One of our clients has been negotiating a sale of his house for the last six months.  The loan balance of his house exceeds the property value.  We recently received final approval from his bank to proceed with the sale and as part of the sale, he would receive a large amount of debt cancelled by his lender.  Sounds like good news, right?

Well, here is the complication: If he closes and accepts the debt cancellation, there is a serious risk under current federal law that he could face a $20,000-plus income tax demand from the IRS. That’s because of the expiration of the Mortgage Forgiveness Debt Relief Act.  Its reauthorization is stuck in political quicksand in Congress.

Enacted in 2007, the Act allows qualified owners who receive debt cancellations from lenders through short sales, foreclosures and loan modifications to be exempt from the federal tax code’s standard requirement: Any amount of debt that is forgiven by a creditor generally is treated as ordinary income to the borrower, taxable at regular rates. During the housing bust and its aftermath, the mortgage debt forgiveness exemption has proved invaluable to large numbers of owners who ended up — often through no fault of their own — with underwater mortgages.

With the expiration of the debt forgiveness statute, owners who do short sales during 2014 cannot be certain that they will avoid taxation on their forgiven mortgage debt. In the absence of a reauthorization by Congress retroactive to Jan. 1, there is a real possibility that short sellers will face hefty income tax hits next year.

The expiration of the law already is affecting the broader housing market. According to data from the National Assn. of Realtors, short sales have plunged from roughly 10% to 12% of home transactions in recent years to between 4% and 5% this spring. Some potential short sellers are opting to file for bankruptcy rather than taking a chance that the law won’t be renewed.

So what’s the holdup on Capitol Hill? In the Senate, the Finance Committee approved reauthorization of the mortgage debt law as part of a larger “extenders” package of tax benefits for a variety of special interests, including wind energy and research and development credits.

But action stopped on the Senate floor when Majority Leader Harry Reid (D-Nev.) refused to allow an amendment that would have killed a controversial 2.3% excise tax on medical devices that is a funding source for the Affordable Care Act. Republican critics of the healthcare law believe that an amendment eliminating the tax could pass the Senate, but Reid is steadfast in refusing to allow any votes before the November elections that could affect Obamacare.

In the House, Ways and Means Committee Chairman Dave Camp (R-Mich.) is taking a go-slow approach on all tax law reauthorizations. There is no scheduled date for consideration of mortgage forgiveness.

All of which leaves my clients — and many other owners across New Jersey — in tax-code limbo. Congress may yet retroactively extend the debt forgiveness law late this summer or in a post-election lame-duck session. Or even next spring. Tax analysts and lobbyists say that there is strong support for renewing mortgage forgiveness relief, and that the odds are better than even that it will happen.