WASHINGTON — The fate of a measure that provided key tax relief to distressed homeowners is hanging in the balance as Congress debates a larger package of tax extenders.

Lawmakers allowed a law to expire last year that prevents the Internal Revenue Service from taxing mortgage debt forgiven or canceled as a result of modifications and short sales.

But industry analysts expect Congress to retroactively extend the measure if lawmakers can pass a larger bill that includes roughly 50 tax provisions important to many businesses.

"As long as the extender package moves, which might be in a few months, we would anticipated this being included," said Edward Mills, a policy analyst for FBR Capital Markets.

House Ways and Means Committee Chairman Dave Camp, R-Mich., is preparing to release a draft of his tax reform bill on Wednesday.

Senate Finance Committee Chairman Ron Wyden, meanwhile, is said to prefer a smaller tax-extender bill that will serve as a "bridge" to more substantial reform. Wyden has stressed that extending the Mortgage Debt Forgiveness Debt Relief Act is critical.

"That is one that I think is very important," Wyden said recently at a University of South California law school event. "This is about as basic for people who are hurting as you can get."

Industry representatives said they are hopeful the extension will be included in a final bill.

"There is a recognition that this specific extension needs to happen," said Jamie Gregory, a lobbyist for the National Association of Realtors.

But the uncertainty surrounding the issue is already having a negative impact in the mortgage market, some said.

"Few, if any, will be doing short sales or principal reductions until it is certain they will get the tax relief," Mills said.

The issue is important for struggling borrowers. A new study by the Urban Institute estimates 2 million loans are seriously delinquent or in foreclosure. Many of those borrowers could benefit from a short sale or deed-in-lieu transaction. Without the protection of the mortgage forgiveness provisions, "many of these borrowers stand not only to lose their homes, but also face large tax bills," the study warns.

The study, by Laurie Goodman and Ellen Seidman, estimates that 160,000 borrowers could benefit from loan modifications that feature principal reductions over the next two years.

The study notes that several major banks and servicers have recently agreed to provide principal reductions in settlements with the Department of Justice and state attorneys general.

"We expect to see a series of additional settlements in the coming year, with much of the restitution in the form of principal reduction," the study says.

But inaction by Congress jeopardizes the relief these settlements could bring. "The timing of the expiration Mortgage Debt Forgiveness Debt Relief Act is thus particularly unfortunate because it undermines the effectiveness of an increasingly utilized tool to reduce foreclosures," Seidman and Goodman say. "In the meantime, however, uncertainty over its renewal has made it increasingly difficult for lenders and borrowers alike to take actions that will be beneficial to both parties."

Meanwhile, housing and mortgage industry groups have yet to mobilize to ensure mortgage debt relief provision will be passed because of the slow start by tax writing committees. "I think there are lots of people that are just starting to engage in this debate," Mills said.

Privately, some industry groups also appear to be waning on their enthusiasm for mortgage debt relief. One source who spoke on condition of anonymity said that if borrowers hadn't taken advantage of a short sale or modification over the past few years, another extension would not help them.

Mills noted that some Republican members of Congress also strongly oppose principal reduction. They are concerned that new Federal Housing Financial Agency Director Mel Watt might permit principal reductions on Fannie Mae and Freddie Mac loans for the first time.

Keeping the mortgage debt forgiveness measure out of a tax extender bill could be one way to block Watt's ability to do principal reductions. But it would "push more people into foreclosure as opposed to keeping them in their homes," Mills said.

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