(Bloomberg) -- Bank of America Corp. must set aside $490 million of its $16.7 billion settlement to cover taxes that borrowers face on forgiven mortgage debt -- a step taken by the Justice Department to give homeowners relief that Congress had not provided.

The bank’s accord with U.S. and state authorities to settle claims over flawed bond sales is the first major settlement to include funds to be used in case lawmakers failed to extend forgiveness on home-loan debt reductions. The tax credit expired on December 31.

The relief is designed to avert foreclosures, particularly in areas where home values are depressed, by letting borrowers shrink mortgages or sell homes for less than the amount they owe without having to pay taxes on the difference. It’s one of many provisions that have been stalled amid disagreements between Democrats and Republicans, and the Bank of America settlement is sparking renewed calls for lawmakers to act on it.

The funds set aside in the settlement would only cover part of borrowers’ tax bills. And those getting loan reductions under earlier settlements with JPMorgan Chase & Co. and Citigroup Inc. could be required to treat that aid as income unless the law is changed.

“Until Congress acts, the hundreds of thousands of consumers we have sought to help through our settlements with JP Morgan Chase, Citigroup and now Bank of America may see a significant tax bill just as they are beginning to see the light at the end of a dark financial tunnel,” Attorney General Eric Holder said during a news conference in Washington.


Short session

Congress may take up the bipartisan Mortgage Forgiveness Tax Relief Act, which would retroactively eliminate the taxes for 2014 and extend the break through 2015, in the short session that takes place between the November elections and the end of the year.

Still, housing-industry groups say that eight months without the provision in place has already contributed to a slowdown in short sales, which enable homeowners to sell their properties for less than the outstanding balance of their mortgages. They have accounted for less than a third of distressed sales, with foreclosures making up the rest, so far this year, according to the National Association of Realtors. Short sales were nearly half of distressed sales in the second half of 2012.

“Taxing forgiven mortgage debt as income is an unfair practice that also incentivizes defaults and foreclosures, which could torpedo the housing recovery,” NAR president Steve Brown said in a statement.

 

Reduces aid

The break doesn’t create much lost tax revenue because borrowers who are at risk of losing their homes aren’t likely to be able to pay additional taxes, according to David Stevens, president of the Mortgage Bankers Association. Earmarking funds for taxes in a settlement reduces direct aid to consumers, he said.

“You’d like the dollars to stretch as much as possible for the families who are at risk,” Stevens said. “If in one of these bank settlements they not only have to cover the principal reduction but also the potential tax payment back to the IRS, those funds are being diverted from what could potentially help another family.”

A House bill to extend the provision is sponsored by Rep. Tom Reed, R-N.Y., and is co- sponsored by 78 Democrats and 59 Republicans. The companion bill in the Senate, proposed by Democrat Debbie Stabenow of Michigan has 24 cosponsors, two of whom are Republicans.

Extending the provision through Dec. 31, 2015, would save taxpayers $5.4 billion, according to the congressional Joint Committee on Taxation.

The bill is H.R. 2994.