One of the most controversial and paradoxical real estate and mortgage finance stories to hit the media in recent weeks was that of a newly crafted real estate tax bill - the so-called Mortgage Forgiveness Bill of 2007. The bill, which may help you hold onto your money if you face foreclosure but will likely hit you hard in the wallet if you own a second home, was drafted by Democrats and approved by the powerful House Ways and Means Committee.

Rising Foreclosures Led to the Drafting of the Bill

During the past two years, a number of economic factors have conspired to create a perfect storm of problems for many homeowners. First of all, prices of residential real estate fell precipitously. Then, as interest rates rose, the monthly payments for many adjustable rate mortgages jumped. Next the mortgage industry hemorrhaged, thanks to the volume of bad loans and delinquencies, and this trouble spilled over into other areas of the financial industry. In an attempt to control losses and appease government regulators and investigators, mortgage lenders tightened their guidelines for approving loans - after a long period of lax standards and "easy money".

Just as homeowners realized the imminent danger of rising adjustable rates and rushed to refinance into more affordable conventional fixed-rate loans, the ability to refinance got harder as loan applications became much more stringent. As the challenges for homeowners increased, so did the number of foreclosures.

Lenders May Show Leniency, but the IRS Does Not

Sometimes banks and mortgage companies will forgive a portion of the debt owned to them, in order to process delinquent loans in the most cost effective manner. Lenders typically lose about 50 percent of their investment when a property goes to foreclosure. So forgiving debt can actually save them money in the long run, by encouraging third-party investors to step in and buy the house before it goes to foreclosure and fetches less money on the auction block. And many government officials - including the President - have asked that lenders show flexibility to homeowners faced with foreclosure, so there is an added incentive for banks and mortgage companies to work out arrangements that are mutually beneficial for lenders and borrowers.

Most homeowners who have part of their debt forgiven are relieved. But many are shocked to find out that under current tax law the forgiven debt is taxed as ordinary income. In other words, if your lender forgives $20,000 of your mortgage debt, the IRS will immediately tax that $20,000 as extra income. Those taxpayers recovering from mortgage problems are already in financial crisis, so paying a hefty tax can easily make a bad situation even worse.

The New Bill Would Cut Out the Tax but Repay it by Curbing a Tax Break

If the Mortgage Forgiveness Bill of 2007 passes and becomes law, homeowners facing foreclosure won't be responsible for paying taxes on debt forgiven by lenders. That is the main focus of the bill, and is great news for those homeowners.

But in order to make up for tax revenues that will be lost if the bill goes through, a major tax break for those who own second homes will be drastically trimmed.

Under current tax law, a married couple is entitled to a tax break of up to $500,000 worth of profit on the sale of a second home, as long as they have lived in it for at least two consecutive years within the five year period before they sell. Single people can claim a tax exclusion worth half as much, or a maximum of $250,000. (Of course gay couples still face tax discrimination in the USA because it is illegal for them to marry, so gay and lesbian couples who buy a second home together are only eligible for the $250,000 tax break offered to singles.)

One clever way to take advantage of the current law is to buy a second home - for instance, a vacation property - and live it for two years. Then you sell and take your profits - and your tax break - before moving back into your first home. But under the proposed new legislation, the tax exclusion would instead be based upon how many years you live in the second home. The longer you live there, the bigger your tax perks. For the most part, the big tax break offered to those who sell their second homes would be severely curtailed, and numerous opponents of the provision say it undermines a tax incentive that promotes investment that helps the economy.

But, ironically, the bill has the support of many of America's largest real estate industry organizations, including the National Association of Realtors, the Mortgage Brokers Association, and the National Association of Home Builders. One reason they support it is that while it does slim down the tax exclusion, it nevertheless preserves it - instead of totally eliminating it.

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