As reported by David Dayden at Firedoglake, short sales have increased significantly in the third and fourth quarters of 2012. This is largely due to the fact that 1) the National Mortgage Settlement incentivizes short sales; and 2) the tax exemption for forgiven mortgage loan balances expires at the end of this year.
To the best of my knowledge, there has not been significant action on the pending legislation designed to extend this tax break beyond December 31, 2012. This means that homeowners who complete short sales next year will be faced with a massive tax bill if their lender agrees to forgive a portion of the loan balance. Once this "income" is realized, it is too late to file bankruptcy and avoid the tax liability -- homeowners will have to wait three years to discharge it.
If Congress does not act to extend (or revive) this tax break, I expect that we will see an upswing in bankruptcy filings as more homeowners are forced to sever their personal liability on their home loans. That said, I don't think that an increase in bankruptcy filings is necessarily a bad thing, however, it may force people into bankruptcy who would not otherwise need to file.
What will almost certainly happen is that the housing market will dip down again. Short sales are a good thing for the economy because property is changing hands from one person to another. Most bankruptcies end with a surrender of the property or a foreclosure of the property. In either event, the propety usually ends up being bank-owned for a period of time. Those vacant properties then further depress the prices for homes in their area. The depressed housing values then stifle or reverse the soft recovery that we are currently seeing.
Another consequence of failing to extend the tax break will be the damage it will do to loan modification programs. No sane homeowner would take a loan modification if it includes a principal reduction that is taxable. Banks that are entirely forgiving second mortgages will be doing underwater homeowners no favor at all -- they will be exposing those homeowners to massive tax liability.
While this post may seem a bit repetitive of my other posts on this subject, it is because this topic is not receiving the coverage it demands.
Cutting the legs out from under short sales and principal reductions will likely have a more significant impact on the nation's economy than going over the fiscal cliff. We want to keep people in their homes and paying their mortgages. We want to transfer homes from one person to another person. If we neuter short sales and loan modifications, we'll see more empty properties that further depress property values.
In either event, I hope that Congress acts on this matter before going home for the holidays. If it does not, I certainly hope that the first order of business in 2013 is reinstating the tax break. If not, we'll certainly see a sharp uptick in bankruptcies and sharp downswing in housing values.