Q: My neighbors bought a home for their mother, who has since passed away. They owed $125,000 on the mortgage. The bank allowed them to do a short sale for $56,000. The three daughters who bought the home for their mother have considerable assets. How can they be forgiven for this debt by the IRS if they are not distressed?

The people who are doing the short sales are ruining the values of our homes, yet we have always made our payments on time, and owe much more than these short sales. Can you please explain this to me?

Q: My neighbors bought a home for their mother, who has since passed away. They owed $125,000 on the mortgage. The bank allowed them to do a short sale for $56,000. The three daughters who bought the home for their mother have considerable assets. How can they be forgiven for this debt by the Internal Revenue Service if they are not distressed?

The people who are doing the short sales are ruining the values of our homes, yet we have always made our payments on time, and owe much more than these short sales. Can you please explain this to me?

A: A month ago, I wrote about the Mortgage Debt Forgiveness Act, under which some folks who sell their homes for less than they owe on it (e.g., a short sale) are exempt from being charged income tax on the debt that is forgiven by their lender(s), if the short sale is completed before the end of 2012. Many upside-down homeowners who are staying on time with their payments, like yourself, have cried, "That’s just not fair!" This took me back to my childhood, the days when I would say those same exact words — "it’s not fair" — only to hear my Dad, a former Marine, deadpan, "Life isn’t fair."

I won’t be so gruff as my Dad, but I submit to you that (a) your diligent on-time payment history has and will be rewarded; (b) life, and the situation are not fair, but fairness is beside the point here; and (c) your interests are better served by this law than they would be without it.

Mindset Management

First things first. The level of detail you have provided isn’t sufficient to fully understand your neighbors’ situation. Was the property owned by one daughter, all the women, the mother’s estate or a trust? That would have a bearing on why a short sale would have been allowed. Also, many people who appear to or once did have "considerable assets" are actually drowning in credit-card debt, upside down on their homes, and taking a bath on the stock market — looks can be deceiving. My point is that there’s a lot about that scenario that may not be as it appears, so don’t assume that they are in an enviable position.

On the other hand, don’t assume that your position is unenviable, or that you are a sucker for being the nice guy and paying your mortgage and other bills on time. The algorithms used to calculate FICO scores were recently revised to render short sales about equally as damaging to the seller’s credit as a foreclosure. In the credit-crunched market we’re facing these days, having a stellar credit score is a very valuable currency, which you can obtain only by doing what you are doing and paying your bills on time. Those who have done short sales or lost their homes to foreclosure will simply not have the same access as you do to credit and even certain employment opportunities, which require a strong credit history.

Need-to-Knows

When it gets down to your question of why the IRS would allow this to happen, first let’s be clear — it is a mortgage lender who actually forgives debt; all the IRS is doing right now is refraining from charging income tax on debt that is forgiven by the lender. And let me tell you what — it may not seem fair, but it is actually somewhat slowing the hemorrhage in your home’s value. Let me explain. …CONTINUED

Ordinarily, the IRS views both foreclosures and short sales as taxable events. However, when a homeowner owes more on their home than its fair market value, the taxes they stand to incur from a foreclosure are often less than the income tax that would arise from a short sale. This creates a major tax incentive for people to simply walk away and surrender their homes to foreclosure, rather than going through the home marketing, showing and bank-negotiating hassles of a short sale. In fact, before the Mortgage Debt Forgiveness Act was passed, I actually saw homeowners in my area consciously electing to walk away, because they couldn’t afford the thousands of dollars in income taxes they would face if they did a short sale.

Now, if you think these short sales are devastating the value of your home, imagine what would happen if every short sale on your block were, instead, a foreclosure. You would have a home that stood vacant for months or longer, providing a nice cozy target for vandals, squatters and other criminals. Your city and state would be out property taxes for that time, as the banks who own these places often don’t settle the property taxes until they resell. And, in the end, the place would be sold for probably less than the short-sale price, depressing your home’s value even further.

To clarify, the Mortgage Debt Forgiveness Act also exempts homeowners from incurring income taxes on debt forgiven due to loan modifications resulting in principal reduction, but applies only in situations where the debt forgiven was on a mortgage used to buy, build or improve the home, or a loan that refinanced such a mortgage. If you are considering a short sale, faced with foreclosure, or even working on a loan modification, you should really discuss the possible tax implications with your own tax professional.

Bottom Line: When it comes to these issues, fairness is really not even a value we have the luxury of catering to. The reality is that these stimulus and recovery provisions are really about damage control and stopping the hemorrhage of lost wealth and home values. While it may seem unfair to you, it would be even less fair and depresses your home’s value even further to maintain rules that encourage people to walk away and dump their homes back on the bank.

Tara-Nicholle Nelson is author of "The Savvy Woman’s Homebuying Handbook" and "Trillion Dollar Women: Use Your Power to Make Buying and Remodeling Decisions." Ask her a real estate question online or visit her Web site, www.rethinkrealestate.com.

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