A key tax break for underwater homeowners considering short sale was extended as part of Congress’s fiscal cliff deal.

The Mortgage Forgiveness Debt Relief Act, which was signed into law in 2007, exempts homeowners from having to pay federal taxes on the balance of their mortgages after a foreclosure or short sale. Borrowers who receive partial loan forgiveness from their lenders also benefit from the exemption.

The tax break had expired at the end of the year, causing concern among housing advocates and homeowners who were in the process of selling their homes through a short sale.

The law has been extended until the end of 2013. Without the extension, these distressed borrowers would have been hit with huge tax bills. That’s because any housing debt that is forgiven or written off by the lender is treated by the IRS as income.

“If they hadn’t done it, it would have meant that people would have no reason to do a loan modification or a short sale,” says Kathleen Day, spokeswoman for the Center for Responsible Lending, which had been advocating for the extension of the tax break. “All the things that banks and mortgage holders are doing to avoid foreclosure would have gone down the drain.”

Uncertainty about whether Congress would deal with the expiring law in time made many sellers nervous about the potential tax implications.

Patty Da Silva, a short-sale specialist and owner of Green Realty Properties in Davie, Fla., says many of her clients were concerned and some sellers were waiting to see if the law would be extended before listing their homes for sale.

“They were very worried because they did their math and the math was really scary,” she says.

For instance, without this tax break, if the lender allowed a homeowner to sell for $100,000 less than the amount owed on the mortgage, the seller could be hit with a tax bill of more than $20,000. Homeowners who could prove they were financially insolvent at the time of the sale, could request exemption when filing their taxes. But this law gives homeowners more certainty about what to expect.

“I had a client call crying that her short sale did not close,” Da Silva says. “She was so upset. She said I can’t pay this. Now I’m going to let her know that she can cry of happiness.”

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