A nice stocking-stuffer from Congress

USAToday reports that Congress has temporarily done away with the "debt forgiveness" tax that would usually result when a borrower defaulted on their mortgage and the house went back to the bank.

The tax break is retroactive to January 1st, 2007 with a planned expiration of 2009 and is aimed at helping ease the pain of foreclosures that began to mount earlier this year.

Shortly before adjourning last week for the year, Congress approved a tax-relief bill designed to help families who had a portion of mortgage debt forgiven. Some families have had such debt forgiven through a foreclosure, a short sale or a loan restructuring that enabled them to stay in their homes. (In a short sale, a home is sold for less than the amount of the loan.)

Ordinarily, forgiven debt is treated as taxable income. In the past, families who lost homes because they couldn't afford mortgage payments were sometimes stuck with a huge tax bill.

The tax "is a double whammy, and it's kind of a surprise whammy," since most don't realize that forgiven debt is taxable, says Mel Schwarz, partner at Grant Thornton's national tax office.

The law of unintended consequences dictates that this might not help too many families and that it will only make the foreclosure situation worse.

Here's why.

The old debt forgiveness tax only applied to the amount of canceled debt that exceeded a (former) homeowner's net worth. In other words, if you had $100,000 of debt canceled but on the day after the house was sold, your net worth was only $5,000, you only owed taxes on $5,000.

While there are no statistics available on the subject, it would not be an unreasonable guess that the bulk of the foreclosures in the subprime sector are probably not too different than the above example (in many case the net worth being negative) and, as a result, there's not a whole lot of "tax relief" to be had.

The potentially more important case involves more "well-to-do" trade-up buyers who may have gotten in over their heads back when everyone was going gaga over real estate and are now looking to walk-away from their upside-down McMansions without getting hammered at tax time.

For someone who has a sizable retirement account, the old tax rules presented big problems because if you had $100,000 in debt forgiveness but retirement accounts worth $150,000, then you would have probably owed taxes on the full $100,000.

This may have unintended consequences in mid-range to upper-range housing where one obstacle to walking away from an "investment gone bad" has now been removed.

Fortunately, Congress saw fit to have this apply only to principle residences, so second-home buyers and speculators will get no relief at all.