A special exemption of up to $2 million per household in principal reduction and other aid is set to expire at year's end. The exemption has been in place since 2007.

Housing advocates and lawmakers are worried that the exemption will disappear just as thousands of homeowners are receiving large amounts of mortgage debt relief from the nation's five largest banks as part of a national settlement of foreclosure abuse investigations.

Mortgage debt that is forgiven by a bank as part of a principal reduction, short sale or foreclosure must be reported as income by the homeowner and is subject to taxes. The lender reports the amount forgiven on a special Internal Revenue Service form.

But in 2007, Congress enacted the Mortgage Forgiveness Debt Relief Act to give struggling homeowners a break. If the debt is forgiven because of a drop in a home's value or a decline in the owner's financial condition, up to $2 million of the relief for couples filing jointly is exempted from federal taxes.

The exemption on what has been called shadow income - relief that can amount to tens or hundreds of thousands of dollars - originally was supposed to expire at the end of 2010. But with the housing market and economy in free fall in 2008, Congress extended the break until the end of this year. While the housing market recently has shown signs of turning the corner, housing advocates said the exemption is still needed.

Rep. Jim McDermott, D-Wash., says the expiration of the provision is a "hidden time bomb."

McDermott and other lawmakers are expected to push for an extension of the special tax exemption when Congress returns from summer break next week, but even with bipartisan support it's unlikely to get a vote before the November election.

To comment on this story, contact Darren Waggoner at darren.waggoner@sourcemedia.com

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