The Mortgage Forgiveness Debt Relief Act, a law temporarily amended the federal tax code to allow mortgage debt on a principal home that is canceled by a lender through a loan modification, short sale or foreclosure to escape taxation as ordinary income, is set to expire on December 31. The prospect is scaring the hell out of loan owners. If this law is not extended, millions of loan owners who plan to sell over the next several years will have to claim potentially hundreds of thousands of dollars of taxable income on the sale.
The Mortgage Forgiveness Debt Relief Act was originally passed out of necessity. The tax bills were going to push millions of insolvent former debtors into bankruptcy. It seemed like the compassionate thing to do for loanowners who bought at the peak and already lost their down payments and their homes. However, the issue is not that simple. By forgiving mortgage debt on all borrowers who short sale, the Ponzis are going to escape taxation on the money they took out. Ponzis extracted hundreds of thousands of dollars in mortgage equity withdrawal — money that was used and spent as income. Ponzis should pay income tax on this money. It was income to them.
The reasonable compromise
No effort was made to separate the wheat from the chaff when administering this tax break, and this created a situation where HELOC abusers and Ponzis really were given free money. My proposal is simple. Extend the tax break only for resale amounts less than the original purchase prices of the property. If the debt exceeds the purchase prices of the property, this money was not the original down payment, and the excess truly was “income” to the borrower that should be taxed. For example, if a loanowner paid $500,000 and sells for $300,000, they pay no tax. However, if a loanowner paid $300,000, then borrowed $1,000,000, and sells for $650,000, they will have to pay tax on the $350,000 they were short on their mortgage.
This compromise is easy to administer because the original purchase price is known. It bails out the people who were victims of bad timing, and it charges an appropriate income tax on Ponzis who were using mortgage equity withdrawal as a source of income. There isn’t really a reasonable objection to this compromise other than it will cause the bankruptcy of a large number of Ponzis. If that happens, too bad. They don’t deserve a tax break for their irresponsible borrowing.
By Kenneth R. Harney — December 9, 2012
WASHINGTON — Patrick Boris, a banquet chef in Las Vegas, is inching toward his own “fiscal cliff,” 2,100 miles away from the political brinkmanship underway in Washington.
If Congress and the White House don’t solve the fiscal impasse this month, Boris figures he could owe federal income tax on more than $100,000 in forgiven mortgage debt following the short sale of the two-bedroom townhouse he plans to sell next year — a personal financial “disaster,” in his words.
In Sacramento, Elizabeth Weintraub, a real estate broker who specializes in short sales, says many of her clients have potentially taxable exposures on $200,000 or more in negative equity balances on their short sales next year if Congress fails to act. …
“This is ludicrous,” she says. “These people already are on the losing end. Now it could get much worse.”
First, it will cause the volume of short sale listings to plummet. The housing market is already suffering from an extreme shortage of inventory, and if short sale listings disappear, very little will be available for sale.
Second, more borrowers will game the system by applying for loan modifications that will ultimately fail. Particularly here in California where dual tracking is prohibited starting January 1, everyone who is underwater will play the game. Many people who would otherwise have sold their homes will chose to rent them out instead.
Third, lenders will be under more pressure to process foreclosures to replenish MLS inventories and boot out committed squatters. With no option for a short sale, those who don’t bother playing the game with loan modifications will strategically default thus forcing lenders to deal with them via foreclosure.
• Nationwide, according to mortgage industry estimates, about 11 million owners are underwater. New data generated for this column by realty information company Zillow indicate that the average negative equity of owners who are underwater — their loan balances exceed the property value — is higher than $90,000 in more than 64 local markets and more than $50,000 in 470. The average negative equity among such owners nationwide, according to Zillow, is $73,163.
About a third of the sales on the MLS are short sales. This number will fall to near zero if the tax break isn’t extended. realtors everywhere will starve.
The highest average negative equity among owners who are underwater is in Key West, where it exceeds $185,600. In San Francisco, it’s $153,194; Los Angeles, $134,400; New York, $126,500; the Northern Virginia suburbs of Washington, $114,000; Miami-Fort Lauderdale, $99,900; Las Vegas, $99,000; and Seattle, $91,000, to name just a few.
Lenders would be happy to see prices rise back up to the peak due to the lack of inventory, but the markets are so far below the peak in most locations, it will take far too long for such price increases to happen.
• Federally regulated Fannie Mae and Freddie Mac own about 4 million mortgages that are underwater, and as of Nov. 1 began encouraging owners who are current on their payments but facing a financial hardship to apply for short sales that forgive their loan balances. All participants in these short sales who close after Jan. 1 could be subject to federal taxation on the forgiven balances if Congress does not extend the law.
• Forty-one state attorneys general recently appealed to the House and Senate to pass an extension so as not to disrupt the $25-billion nationwide “robo-signing” settlement they negotiated with five major lenders. Among other provisions, the settlement encourages lenders to forgive billions of dollars in mortgage debt next year and beyond. Failure to renew the law, said Nevada Atty. Gen. Catherine Cortez Masto, would cause families who are already facing financial distress to be “stuck with an unexpected tax bill” that could deter them from “participating in this historic settlement.”
Fortunately for the banks, they are close to reaching their write-off goals under the loan settlement. However, if short sales stop, it will take lenders longer to get to their accounting goals.
What’s the outlook? There are no indications that either House Speaker John A. Boehner (R-Ohio) or Senate Majority Leader Harry Reid (D-Nev.) plan a separate vote on a mortgage debt forgiveness extension, essentially freeing it from the game of political chicken underway. Whether a grand bargain including an extension can be struck is anyone’s guess — and underwater short sellers’ ongoing nightmare.
I feel bad for the peak buyers who are stressing over this issue. This will trap them in their homes until prices reach their loan balances.
I feel nothing for the Ponzis who are facing the consequences for their foolish borrowing. If they get a break, it will be a travesty of justice.
I wish lawmakers had the wisdom to see the difference between these two vastly different groups of borrowers. The compromise I outlined above would solve the problem in a way that does not cause moral hazard. I urge them to consider it while they deliberate the fate of loanowners everywhere.
Should these borrowers pay taxes or not?
The former owners of today’s featured REO are a typical example of people who don’t deserve a break under the tax code. They extracted over half a million dollars in mortgage equity withdrawal they spent as income. If they get a tax break, this income they spent goes untaxed, and they are the beneficiaries of truly free money.
- This property was purchased on 1/21/1998 for $453,000. The owners used a $300,000 first mortgage and a $153,000 down payment.
- On 4/17/1998 they obtained a $100,000 HELOC.
- On 1/25/2002 they refinanced with a $294,000 first mortgage. Apparently, they were paying down their original purchase money mortgage and did not use the first HELOC.
- On 5/17/2005 they refinanced with a $790,000 Option ARM. This $490,000 in mortgage equity withdrawal was not taxed in any way.
- On 10/19/2006 they opened a $200,000 HELOC.
- On 1/31/2007 they refinanced with a $856,000 first mortgage and obtained a $200,000 HELOC.
Let’s say the borrowers sold this property short rather than letting it go to foreclosure. They extracted over $600,000 from the property. It is too much to expect them to pay a few dollars in taxes on this income? I don’t think so.
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Proprietary OC Housing News home purchase analysis
$1,149,900 …….. Asking Price
$453,000 ………. Purchase Price
1/21/1998 ………. Purchase Date
$696,900 ………. Gross Gain (Loss)
($91,992) ………… Commissions and Costs at 8%
$604,908 ………. Net Gain (Loss)
153.8% ………. Gross Percent Change
133.5% ………. Net Percent Change
6.3% ………… Annual Appreciation
Cost of Home Ownership
$1,149,900 …….. Asking Price
$229,980 ………… 20% Down Conventional
3.86% …………. Mortgage Interest Rate
30 ……………… Number of Years
$919,920 …….. Mortgage
$216,850 ………. Income Requirement
$4,318 ………… Monthly Mortgage Payment
$997 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$287 ………… Homeowners Insurance at 0.3%
$0 ………… Private Mortgage Insurance
$0 ………… Homeowners Association Fees
$5,602 ………. Monthly Cash Outlays
($1,108) ………. Tax Savings
($1,359) ………. Equity Hidden in Payment
$302 ………….. Lost Income to Down Payment
$307 ………….. Maintenance and Replacement Reserves
$3,745 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$12,999 ………… Furnishing and Move In at 1% + $1,500
$12,999 ………… Closing Costs at 1% + $1,500
$9,199 ………… Interest Points
$229,980 ………… Down Payment
$265,177 ………. Total Cash Costs
$57,400 ………. Emergency Cash Reserves
$322,577 ………. Total Savings Needed