A law exempting homeowners from paying income tax on debt forgiven by the bank in a short sale is set to expire at the end of the year. If it is not renewed, it could affect the local short-sale market, experts said.

The Mortgage Forgiveness Debt Relief Act of 2007 allows taxpayers to exclude income from the discharge of debt on their principal residence. This comes up when homeowners and their bank agree to a short sale, meaning the sale price of the house is not enough to clear the mortgage. If the law expires, that difference, or shortage, would have to be included as income on the homeowners' income tax filing.

"If it is not extended, then there could be a rush of homes that hit the market before the end of the year as homeowners vie to beat the deadline," said Troy Toureau of McLean Mortgage Corp. "Unfortunately, by then there will not be enough time for most to sell a home and close, especially since the bank must approve all short sales."

Even under new short-sale guidelines, banks have up to 30 days to make a decision.

"With the results of the election and the debate on the budget up in the air, there is no telling whether this legislation will be extended during the lame-duck session of Congress," Toureau said.

Given the cost of the proposal, and the desire of Congress to raise revenues to reach a budget agreement, there is a possibility that an extension will not occur.

"I believe Congress will extend it," said Allen DeLeon, a founding partner at the accounting firm DeLeon & Stang. "It is really pretty onerous to have to pay tax on forgiven debt. Businesses can add that debt to the basis of the property."

Toureau did not rule out a short-term extension of the law, as it would not be unusual for Congress to defer the decision to members taking office after the first of the year.

"In the long run, if the act is not extended, I believe that this will affect the short-sale market negatively in many states," Toreau said. "In my opinion, homeowners that are underwater are more likely to consider whether they can refinance as an alternative to a short sale."

Toureau said lower payments might make it easier for homeowners to wait for the market to recover. In many areas, new mortgage payments may be less costly than renting after foreclosure.

"From a tax planning standpoint,I would encourage homeowners to speak with their accountants first," DeLeon said. "My advice would be to try and expedite the short-sale process and get it done before the end of the year."