By NICK TIMIRAOS

Troubled homeowners who get a break from their mortgage lenders might not be so lucky with Uncle Sam, and could face hefty tax bills unless Congress acts to extend a key provision.

The tax provision currently allows some homeowners—mostly those facing foreclosure—to avoid paying taxes on certain relief they receive on their mortgages.

The provision covers mortgages where lenders forgive a portion of the principal, a key component in the $25 billion federal-state settlement over mortgage-foreclosure abuses. It also affects homeowners who do “short sales,” where banks agree to allow a property to be sold for less than the debt owed.

In 2007, as the foreclosure crisis erupted, Congress exempted homeowners from treating some forgiven mortgage debt as taxable income, in a bid to encourage banks and borrowers to seek foreclosure alternatives. But that provision is set to expire Dec. 31, causing headaches for homeowners such as Brad and Connie Bates.

Mr. Bates has been working since August to get his mortgage company, Bank of America Corp., BAC -0.41% to approve the sale of his three-bedroom home in St. Petersburg, Fla., for less than the $180,000 he owes. He has a buyer willing to pay just $65,000, and the shortfall would be counted as income if Congress doesn’t extend the tax-relief provision.

“If they don’t get together and deal with this tax problem, it just creates a disincentive to do the responsible thing,” says Mr. Bates, a 58-year-old retired Air Force veteran who bought the home in 2001. “The tax hit is going to be enormous.”

While the real-estate industry has focused on potential caps to the mortgage-interest deduction, the expiration of the 2007 tax provision “is the most important piece of housing legislation [that] no one is talking about,” said Isaac Boltansky, a policy analyst at Washington-based Compass Point Research & Trading, a dealer broker for institutional clients.

Rep. Jim McDermott (D., Wash.), who has introduced a three-year extension of the tax measure in the House of Representatives, said: “It’s as if you’re handing someone a life ring and then you cut the rope. It doesn’t make sense.” The Senate Finance Committee passed a one-year extension as part of a broader tax package with a 19-5 vote in August.

Mr. McDermott said he is confident Congress will ultimately pass an extension. “There’s no question,” he says.

But the uncertainty over the timing of that extension—which could become ensnared by the broader talks on the “fiscal cliff,” the looming mix of tax increases and spending cuts—is raising the blood pressure of real-estate agents who work with distressed homeowners.

“You may have a large number of people here who sit back and fight the foreclosure process” if the provision isn’t renewed, said Steve Capen, a real-estate agent with Keller Williams Realty in St. Petersburg.

Many of his clients who are trying to secure a short sale are “already in a tough situation,” he said.

Sergei Zhurkov would face a particularly large tax hit for the short sale on his Dunedin, Fla., home. He owes around $750,000 on two mortgages and has an offer of $200,000 for the house. “I have no job. How am I supposed to pay taxes on this?” said Mr. Zhurkov, 62. “It makes no sense. I am completely broke.”

The short sale has been approved by Wells Fargo WFC -0.80% & Co. after a protracted negotiation, but the buyers are having difficulty getting approved for a mortgage.

The looming expiration of the tax provision comes at a critical time for the housing market. Banks have ramped up short sales, approving nearly 340,000 in the year ended in September, according to CoreLogic Inc., CLGX -0.27% a data firm. That has helped to stanch the flow of foreclosures onto depressed housing markets, limiting both price declines and lenders’ losses.

If the tax provision expires, it could also deal a serious blow to the $25 billion mortgage-foreclosure settlement that five national lenders struck with 49 states and the federal government in March. That deal requires banks to use the bulk of the penalties for borrower aid, including at least $10 billion in principal reduction. So far, lenders have forgiven around $2.6 billion on nearly 22,000 mortgages under the settlement, or around $117,000 per homeowner.

Mr. Bates’s short sale has been held up because his mortgage company has said the home is worth at least $135,000. He says his home isn’t worth anywhere near that because of extensive water and mold damage from a leaking roof that he can’t afford to replace.

“The property has basically fallen down over our heads. A short sale is the only way we can deal with this,” Mr. Bates said.

Bank of America has “worked with urgency to help more than 100,000 customers complete short sales this year,” said a BofA spokeswoman. “We are working to help Mr. Bates receive those same benefits.”

The current debt-forgiveness provision is limited to $2 million in mortgage debt and applies only to loans that were used to acquire or “substantially improve” a principal residence. Absent any extension, borrowers would have to prove to the Internal Revenue Service that they are insolvent to avoid the higher tax consequences.

In some cases, homeowners who go through foreclosure would still be left with higher taxable income, if banks agree not to recoup any shortfall between the debt owed and the amount recovered through the foreclosure.

Write to Nick Timiraos at nick.timiraos@wsj.com

A version of this article appeared November 30, 2012, on page A4 in the U.S. edition of The Wall Street Journal, with the headline: Tax Hit Looms on Mortgage Relief.