As Washington and the nation focus on the “fiscal cliff,” a critical protection for underwater homeowners also is about to go over the edge.

The Mortgage Debt Relief Act of 2007 is scheduled to expire at the end of the year.

The legislation allows borrowers to avoid paying income taxes on the amount of principal that is being forgiven as part of a loan modification or a short sale.

If the law expires, homeowners will have to pay taxes on the debt reduction. This is ridiculous.

Consider: an individual buys a home for $150,000. The economy tanks, he loses his job and faces foreclosure. He manages a short sale of the home for $80,000. Unless the law is extended, he would be taxed on the $70,000 debt that is being forgiven, as if the value that doesn’t exist were personal income.

The tax also would be imposed if the bank modified the loan, reducing the principal so that the homeowner could better manage payments. This would be devastating to struggling homeowners, particularly in Florida, among the national leaders in foreclosures.

Slapping a tax on borrowers trying to get back on sound financial ground is no way to revive the economy or the housing market. When the law was written, it was widely expected that housing, and the broader economy, would be back to normal by now. Today, the reasons for passing the act in 2007 remain painfully evident in many communities.

As Mark Goldhaber, a North Carolina mortgage industry consultant, told Bloomberg News, “If these folks are going to have to pay tax on phantom income, it’s very impactful for homeowners.”

And if the law expires, victims of bank fraud who receive settlements under the National Mortgage Settlement would be forced to sacrifice a portion of their compensation.

The federal government and 49 states worked to achieve the settlement with banks accused of using their mortgage servicing operations to defraud and even evict homeowners.

The settlement requires the nation’s five largest loan servicers to pay $21.5 billion to victims.

Much of the compensation will come in the form of reductions of the mortgage principal or lower interest rates.

But as 41 state attorneys general, including Florida’s Pam Bondi, warned in a letter to Congress, any such relief to abused homeowners will be significantly diminished if the Mortgage Debt Act of 2007 expires.

They write that “failure to extend this tax exclusion will result in $1.3 billion in tax increases on the very families who can least afford it.”

Measures in Congress would extend the tax break and spare Americans paying taxes on “assets” that don’t exist.

Congress should heed common sense and the plea of the attorneys general, who wrote:

“Each of our offices receives calls every day from homeowners trying to save their homes or struggling to recover from losing their homes. A home lost to foreclosure depresses future home sale prices, damages the value of surrounding homes, and harms families, neighborhoods and our general economy. Congress must act.”