The tax clock is ticking for homeowners considering short sale and those facing foreclosure. If they don’t officially get rid of their mortgages by the end of the year, they could receive jaw-dropping tax bills — unless Congress acts soon.

The Mortgage Forgiveness Debt Relief Act, which was enacted in 2007 to provide special tax exemptions for underwater homeowners, expires Dec. 31. If the law is not extended, homeowners will have to pay federal taxes on the balance left on their mortgages after a foreclosure or short sale.

“It would affect a lot of people,” says Tony Hutchinson, a senior policy representative at the National Association of Realtors. The trade group has been pushing for the extension of the law.

How much money is at stake?

Without the law, many homeowners could be hit with tax bills for tens of thousands of dollars. Take a homeowner with a mortgage balance of $300,000. If the lender allows the homeowner to sell the house for $200,000 through a short sale, the homeowner would pay federal income tax on $100,000.

In the eyes of the Internal Revenue Service, housing debt that is forgiven or written off is the same as income. If the law expires, forgiven mortgage debt will be taxable. The same applies to foreclosures and to loan modifications in which principal is reduced.

“I’ve had short sales where more than $200,000 is written off,” says Patty Da Silva, a short-sale specialist and owner of Green Realty Properties in Davie, Fla. “For someone in the 30 percent (tax) bracket, that’s $60,000 in taxes.”

Congress will likely approve an extension in the eleventh hour, Hutchinson says. But when it comes to Congress and politics, there is always a risk, especially with the looming fiscal cliff and the pressure the government faces to reduce spending. A one-year extension of the bill would cost the government about $1.3 billion, according to a congressional estimate.

“We need to make sure there is some action taken on this,” Hutchinson says.

Housing advocates are betting their hopes on a broad bipartisan bill approved by a Senate committee in August. If the bill makes its way through Congress, it would extend the tax break for one year.

Better safe than sorry

Many homeowners and even some real estate agents don’t seem aware of the risk and the damage they would face if the act is not extended, Da Silva says.

“Sellers have been very complacent, and they assume it is going to be extended, but what if it’s not?” Da Silva asks.

For those who don’t want to take a risk, do everything to finalize deals involving debt cancellation by the end of the year, Da Silva says.

“Be as proactive as possible,” she says. “Do everything you can do to close. November and December are going to be very busy months.”

Even if you close by the end of December, make sure the lender actually writes off the debt before the deadline, says Gil Charney, principal tax researcher with The Tax Institute at H&R Block.

“Communicate with the lender,” he says.

If you are modifying your mortgage and the lender agrees to reduce the amount you owe, make sure the process is completed in time to benefit from the extension.

For those with homes in foreclosure, there’s not much you can do to speed up the process. But if you know the foreclosure is inevitable and are ready to let go, consider turning over the keys with a deed in lieu of foreclosure to finalize the foreclosure.

How the act works

Once the lender writes off the debt, it will report the amount to the IRS. You should expect to receive Form 1099-C showing the canceled debt amount.

There is no need to panic when you receive this form. All taxpayers, including those who qualify for the exemption, will get the form in the mail if they had debt canceled, Charney says.

Those who qualify for the exclusion will be required to file Form 982 when they file their taxes. The exemption applies only to debt related to a primary home. Mortgages on vacation and rental properties are not exempt under the act.

Alternatives in worst-case scenario

If the law is not extended, homeowners who were financially insolvent when the debt was canceled still have one alternative to reduce their tax bill, Charney explains. In short, if your total debt exceeded the value of your assets — including your 401(k) — at the time the debt was canceled, you can reduce the tax liability.

Say you were insolvent by $25,000, and the short sale amount of debt canceled was $80,000. Then you would be liable for taxes on $55,000, he explains.

For most underwater homeowners, that would still be a pretty hefty bill.

“Even if somebody is not in financial distress, the value that we are talking about here is pretty big. Who has that kind of money lying around?” Da Silva asks. “This is going to cause a lot of panic if (the act is) not extended.”