Function

• Assume a mortgage of $100,000. After repaying $20,000 of the mortgage, the borrow is forced to sell the property because of economic hardship. The borrower is able to sell the home for only $60,000, leaving a gap of $20,000 between the sale price and the current value of the mortgage. Assuming the lender approves this short-sale--the lender is the shorted party--the amount forgiven was counted by the IRS as income for the borrower, until MFDRA. In other words, the borrower had to pay taxes on that $20,000. MFDRA prohibited the IRS from charging that amount as income and taxing it. According to the federal Office of Management and Budget, hundreds of thousands of people who sold their homes at short-sales avoided a big tax hit as a result of the law.
  
  

Expiration

• In 2010 and beyond, the economy and housing market continued to slump and short sales continued. The MFDRA covers short sales only for the years 2007, 2008 and 2009, though. Unless Congress extends the act, any shortfall in a short sale for the years 2010 and beyond won't apply. In other words, a homeowner will not only take a loss on the sale of the home but have to pay taxes on the amount of the loss.
  
  

Loss-Recoup

• Under MFDRA, the lenders weren't permitted as part of a short-sale to recoup its loss from the home. In other words, the lenders couldn't require the homeowner (the seller, in this case) to promise to payoff the shortfall to the lender. In some states, banks are permitted to seek a promissory note obligating the lender to pay off the shortfall between the loan amount and the amount the lender doesn't recover from the short-sale.
  
  

Exception

• The MFDRA excludes from tax forgiveness home equity loans used for any purpose other than home improvement. So if a homeowner used a home equity loan to fund a $20,000 trip to the Pacific Rim or some similar purpose, that money counts against the shortage in a short-sale. In other words, the amount of the home equity loan becomes taxable even under the MFDRA.
  
  

Qualifications

• The MFDRA applies only to the borrower's primary residence, and excludes vacation homes and investment or other properties. Also, there is a cap of $2 million for tax forgiveness. Any amount over $2 million not collected by the lender is taxable.
  
  

State Laws

• With the sunset of the federal income tax forgiveness, some states, like California, have sought to soften the blow by not applying state taxes to the short-sale shortfall. It's less than the federal tax but it does represent savings from paying state taxes. In California, the state forgives up to $500,000 on a principal residence ($250,000 for married/registered domestic partner individuals filing separately). California's law applies to debt forgiveness in 2009 through 2012.