The odds of foreclosure largely correlate with a borrower’s level of indebtedness. A homeowner who’s “underwater,” meaning he or she owes more on the home than it’s worth, is far more likely to miss payments that a borrower with equity. And studies show that principal reductions do a far better job than any other kind of loan modification in helping borrowers maintain payments and avoid foreclosure. If you privilege other modifications through the tax code, like reducing the interest rate, over principal reductions, you punish those homeowners receiving the most sustainable type of modification, and eventually take them off the table, leading to a weaker housing recovery.

“I suggested to Barney [Frank] that we create an exemption for principal reductions,” Miller said. “Barney said to me, ‘Let’s go talk to Richie,’” meaning Richard Neal, the chairman of the tax-writing subcommittee in the House. Neal agreed to help, and the change got added as an amendment to an unrelated bill.

That first exemption lasted three years, but the foreclosure crisis lingered on beyond that. Democrats were able to include an extension in the larger deal that extended all of the Bush tax cuts for two years. Now the law is scheduled to expire again on Dec. 31, 2012. Any debt relief that completes after that date would be taxable.

The difference now is that principal reductions and other debt relief are set to become more widespread. Banks have been extremely resistant over the last several years to grant principal reductions, which forces them to take an up-front loss. Even if, over time, the greater probability of the borrower maintaining the payments makes it more cost-efficient for the bank than the risk of a bigger loss in foreclosure, banks do not want to mark the immediate loss on their books. In addition, mortgage servicers, who manage securitized loans sold to investors, get compensated through a percentage of unpaid principal balance, so principal forgiveness represents a direct cut into their profits.

Because of the mortgage settlement, banks are mandated to forgive at least $10 billion of principal, as a punishment for using false documentation to foreclose on homeowners, among other abuses. Though this is a relatively small amount of forgiveness (homeowners have roughly $700 billion in negative equity on their mortgages), the implications for the borrowers who receive it are significant. A $100,000 principal reduction for a family making the median adjusted gross income of $32,393 would calculate to an additional tax bill of roughly $21,200. And most homeowners threatened with foreclosure and in need of a principal reduction have far poorer finances than the median. “’I’m on unemployment and I just got a $20,000 tax bill?’” said Ira Rheingold of the National Association of Consumer Advocates. “This would be so counter to public policy, it makes absolutely no sense.”

In addition, the tax exemption also covers short sales, which have increasingly become an option for banks and homeowners to avoid foreclosure. In a short sale, the bank agrees to allow homeowners to sell their property for less than the value of their mortgage, forgiving the balance. The borrower walks away from the home without an eviction, the property sells at a higher price in a short sale than a foreclosure sale, and the bank doesn’t have the expense of maintenance and upkeep on the property between eviction and the foreclosure sale. Short sales increased 25 percent year-over-year in the first quarter of 2012. But if the exemption expires, the homeowner would have to pay tax on the balance forgiven by the bank in a short sale, making this option much less attractive.

The mortgage settlement added several other cases where homeowners would have to pay taxes on awards from banks. Under the settlement, up to 750,000 foreclosure victims, who have already lost their homes, will receive checks of $2,000 as compensation for foreclosure fraud. But the settlement language did not make clear that the cash reward represented compensatory damages, and as a result, these checks could be taxed. Similarly, service members stand to get compensation of $116,800 or more, due to a series of violations under the Servicemembers Civil Relief Act, including incidents where banks illegally foreclosed on military members while they were deployed overseas. But because of the vagueness of the language, they could be taxed as well. Rep. Brad Miller said he advised those involved in writing the settlement that they should try to make everything, including the mandated principal reductions, explicitly portrayed as compensatory damages, to ensure the exclusion from tax liability. “They had no idea what I was talking about,” Miller said.

At this point, only Congress can fix this problem by extending the exemption, and there are two parallel efforts underway to do so. Sen. Debbie Stabenow, D-Mich., has sponsored a bill, S.2250, which would prevent taxation on all debt forgiveness, like principal reduction or short sales, through the end of 2013. That bill has 17 co-sponsors, including four Republicans (Dean Heller, Scott Brown, Susan Collins and Johnny Isakson), as well as the support of the White House, which called for it in its proposed budget. Rep. Jim McDermott, D-Wash., has a more extensive bill in the House, H.R.4290, which would not only relieve the tax burden for principal forgiveness, but also exempt the direct cash payments to homeowners from the mortgage settlement. It would also stop banks from taking a deduction for any payments they make for Servicemembers Civil Relief Act violations. That bill has 42 co-sponsors, but no Republicans. “I wanted to put an idea out there and let it cook,” McDermott said. “I can’t ram it through, I can’t get a hearing on it in the Ways and Means Committee. But people can look at it, decide it’s a good idea, take it and shape it.”

Given that this is in essence a tax cut – the Congressional Budget Office estimates that excluding principal reductions from taxation for two more years will save recipients $2.7 billion — many Democrats in Washington believe that Republicans will eventually get onboard. But that’s no guarantee. “I’m not sure we can get that extended,” Rep. Miller said. “Republicans are not keen on principal reduction in the first place. When we extended the law in 2010, that was considered a give to Democrats.” Given that the tax issue would in all likelihood bring principal reductions to a screeching halt, Republicans could view resisting an extension as a way to stop something where they have ideological opposition. And it could be used as a bargaining chip in other negotiations.

In addition, it’s not like Congress has nothing to work on in the lame duck session, where this will probably get decided. Lawmakers must navigate a host of issues, including trillions of dollars in fiscal measures like the Bush tax cuts, the automatic sequester of $1.2 trillion in discretionary and defense spending, the alternative minimum tax and much more. With all this packed into a short space of legislating, the principal reduction issue could easily get lost in the shuffle. And it’s not as if Washington has made a priority out of granting relief to homeowners over the past several years. “In a rational world with a rational Congress, I would not be concerned,” Rheingold, of NACA, said. “But we don’t have that.”

At stake is the future of the housing market itself. Though analysts keep touting a bottoming out of prices and home sales, the numbers suggest that there’s still a long way to go, and the biggest stumbling block remains negative equity. “For us to get to a housing recovery, we really do need significant principal reduction,” said Rheingold. “As we’re seeing the first signs of doing any principal reduction or short sales, if this tax relief is allowed to expire, it would really do tremendous damage.”

But consumer and housing advocates have not engaged on the issue yet, though they have relentlessly demanded more principal reductions. “It’s not something that a lot of us have been thinking or talking about,” acknowledged Rheingold. “We’re thinking about implementation of the settlement, and whether there will be principal reductions, not these other hazards.” Housing advocates have called on Ed DeMarco, the head of the Federal Housing Finance Agency, to authorize principal reductions on loans owned by Fannie Mae and Freddie Mac. And his rejection of this has spurred calls for President Obama to fire him. But this issue, which would punish the beneficiaries of those principal reductions with a giant tax bill, has not generated the same level of outrage.

There’s still time for a fix. An extension would probably get folded into some other must-pass bill at the end of the legislative session, reasoned Sen. Merkley. There’s also the possibility of dealing with it retroactively sometime in 2013, before homeowners get the big surprise on their 2013 taxes. “I’ve heard no one defend the way the law will go,” Merkley said. Rep. McDermott, the lead sponsor in the House, saw options as well. “The legislative process can move very rapidly when it wants to,” he said. “When there’s a will, there’s always a way. What’s troublesome is finding out if anybody cares.”

Peggy Mears, of ACCE, said that her organization would begin to talk to its members about the issue. “We’re going to refuse to give up fighting for homeowners,” she said. “It would be a shame for people in Congress to pull money out of the consumer’s pockets.”

Without a strong push from outside advocates and attention from lawmakers, an extension will be a challenge. And homeowners abused by banks throughout the mortgage process would suffer a final nightmare courtesy of the Internal Revenue Service. “Of all the tax changes likely to expire,” Rep. Brad Miller said, “this is the one that causes me the most concern.”