I’ve had more than a few assurances that Congress would get its act together and pass an extension of the Mortgage Forgiveness Debt Relief Act, so that underwater homeowners who get some debt relief won’t have a big tax bill staring them in the face to make their financial situation even worse. But if that’s the case, you have to wonder why lenders are packing in so many short sales as we near the expiration date.

Homeowners and banks are accelerating sales of properties for less than the amount owed as a U.S. law that gives them a tax break expires at the end of the year.

The transactions, known as short sales, increased by 35 percent in the third quarter from a year earlier, while sales of bank-owned homes dropped 20 percent, according to a report today by mortgage data seller Renwood RealtyTrac LLC. Together, they accounted for 41.5 percent of home purchases in the quarter.

Short sales have accounted for as many as 1.1 million transactions since 2009, helping to reduce the inventory of homes owned by banks that can blight neighborhoods and flood the market. Barring a last-minute extension of the 2007 Mortgage Forgiveness Debt Relief Act, homeowners will be taxed on the forgiven principal. With Congress focused on the so-called fiscal cliff, federal spending cuts and tax-rate hikes set to kick in on Jan. 1, the law may not be extended, leading to a drop in short sales and a rise in foreclosures.

I’m particularly interested in how this will completely screw up the foreclosure fraud settlement. The entire thing was predicated on providing meaningful relief to borrowers who were actually wronged by the manipulation and fraud in the lending process. So here they receive their reward, but they’ll have to agree to pay taxes on it, money they don’t have stashed somewhere, otherwise they wouldn’t be a “troubled borrower.” As a result, nobody will accept debt relief under the settlement.

How those who put together the settlement couldn’t have seen this coming is a total mystery. Or maybe it’s not. At one level, they could have built into the settlement the idea that the relief served as compensatory damages, and therefore not eligible for taxation. However, this would have meant that banks could not write it off as a business expense, as I wrote previously:

The authors of the settlement never made it explicit that the awards were compensatory in nature, which would have accomplished two things. One, it would have made the awards tax-exempt. Two, it would have disallowed banks from deducting the awards on THEIR taxes. Without that language, it’s unknown how the IRS will react. So that’s just another little backdoor bailout.

In other words, the settlement authors never contemplated making the damages compensatory because they wanted to give banks the benefit of tax exemption rather than homeowners. That’s just another little way you can see how the settlement was structured more to the benefit of banks than the people they harmed.

Presumably, if banks do not cover the total relief in the settlement after three years, they have to pay a cash award for the balance. This would hurt their balance sheets more, because rather than just taking air our of mortgage balances they would have to give up real money. This is one part of the reason you see the Financial Services Roundtable pushing to extend the MFDRA (the others include the fact that short sales are more lucrative than foreclosures, and that they have helped prop up a recovering housing market). But governments would then get hard dollars rather than seeing it go to homeowners (I’d have to go back and check to see how that penalty would get distributed).

Short sales account for an incredibly large percentage of all US home sales. This is going to be a disaster in the first quarter without an extension:

Sales of homes in some stage of foreclosure accounted for 20 percent of all U.S. homes sales, the report said. The share was highest in Georgia, at 38 percent, followed by California, at 36 percent; Arizona, at 34 percent; and Nevada, at 31 percent.

Short sales of homes that weren’t in foreclosure rose 17 percent in the third quarter, the data company said, without providing a number because the figure is based on a sampling of the market. Those sales accounted for 22 percent of all U.S. sales, and were the highest in Rhode Island, at 58 percent; Connecticut, at 47 percent; and Massachusetts, at 44 percent, according to the report.

There’s probably no housing analyst even conceiving of the fact that their precious “recovery” is a mirage caused by an expiring tax break, just like the last pseudo-recovery with the first time homebuyer’s tax credit. They should think it over more.

Photo by Images_of_Money under Creative Commons license.