There’s another cliff on the horizon that is about to hit much closer to home for a lot of Americans. It’s not the product of echo chamber hype. It’s a family killer. Worse, unless Congress drops the obstructionist approach, this second cliff is going to be hit soon, and the fallout will be epic.

Five years ago, with the economy in a freefall, Congress passed a tax provision known as the Mortgage Forgiveness Debt Relief Act. Enacted as the housing market imploded, with millions of families suddenly on the verge of losing their homes to foreclosure, the law exempted homeowners from paying a tax on certain forms of debt relief. It allowed millions of Americans to keep their homes, and avoid economic ruin.

Now, at a critical juncture in our economic recovery, that exemption is about to expire. The timing is atrocious; the stakes are incredibly high. But while the argument for extending it is a no-brainer, there’s no telling when — or even whether — Congress will see how urgent this is and take appropriate action.

To understand why this matters so much, it’s important to understand how burdensome debt relief was in the absence of this law. When a lender agrees to forgive some or all of a strapped consumer’s credit card or mortgage debt in order to recoup at least some of the money owed, the IRS taxes the forgiven amount as extra income

So while an underwater homeowner may feel lucky to have a $100,000 mortgage forgiven, that good feeling quickly disappears when she finds out that it counts as taxable income. Worse, often that phantom income places the debtor in a higher tax bracket. Having dodged the first bullet, they step into a bear trap.

So the crux of the problem is that the debt relief reduces future obligations for people who are short on cash, but it comes with a bill that requires immediate payment (or another payment plan) with cash that doesn’t exist. It’s the sort of bad idea you might expect from folks who have never been in a financial bind — like many of the folks in Congress who concocted it. But what Congress has done, Congress can undo.

The law, as it stands now, makes debt forgiveness tax exempt when related to a mortgage on a consumer’s primary home that is valued at $2 million or less, or was used to buy, build or substantially improve a primary residence, the borrower can avoid the tax burden that normally comes with mortgage forgiveness.
The expiration of that exemption is the cliff we should be talking about.
By Adam Levin on 12/05/2012