Expired Tax Relief Could Increase Pressure on Troubled Borrowers

The Mortgage Forgiveness Debt Relief Act's (MFDRA) expiration may lead to negative pressure on liquidation timelines and recoveries for legacy U.S. mortgage investors if the act is not renewed, according to Fitch Ratings.

Recently expired as of January 1, the MFDRA was signed into law December 2007 with the purpose of aiding underwater mortgage holders. Fitch Ratings projects a negative effect from the MFDRA’s expiration.

The act was designed to provide tax relief by allowing certain borrowers to exclude mortgage debt that was cancelled or forgiven by the lender through a foreclosure, short sale, or loan modification—debt that would normally be considered income for tax purposes.

Without this relief, Fitch expects a decline in the volume of short sales and principal forgiveness modifications. The agency cites three reasons for its projection:

• Without the tax exemption, there is less incentive for distressed borrowers to agree to a voluntary property sale that will not pay the loan off in full, likely increasing the number of involuntary foreclosure sales.
• The MFDRA's expiration provides less incentive for servicers to offer principal forgiveness modifications. The tax burden on the borrower increases the likelihood of redefault.
• Servicers may increasingly opt for principal forbearance, which requires the borrower to repay the reduced principal amount at the end of the loan term.

Congress is currently considering extending the tax relief through 2015 or 2016.