Short sales detered as tax forgivness terminates

Borrowers will pay taxes on forgiven mortgage debt starting next year. Ordinarily, the IRS considers forgiven debt a form of income, which it is. In 2007 Congress passed the Mortgage Foreclosure Debt Forgiveness Act which allowed borrowers who short sell their houses to avoid taxation on forgiven debt. Many borrowers availed themselves of this tax break and extricated themselves from a bad housing situation. In the future, borrowers in similar circumstances will owe enormous tax bills if they receive any mortgage debt forgiveness.

End of mortgage-fix break could mean big tax bills

By Les Christie @CNNMoney December 6, 2013: 10:14 AM ET


A tax break for struggling mortgage borrowers ends Jan. 1 and that could mean big tax bills — and financial hits for their neighbors.

Say a family is behind on their mortgage and the bank cuts them a deal, maybe reducing the loan principal or forgiving the mortgage balance after a “short sale” in which the seller owes more than the final price.

Under traditional IRS rules, the amount of that debt forgiveness would be taxable income.

That temporarily changed in 2007 when Congress passed the Mortgage Foreclosure Debt Forgiveness Act. That law is set to expire at year’s end.

Congress could pass a special tax of 100% on the gain from debt forgiven through an eminent domain action. That would effectively neutralize the eminent domain threat to mortgages because any debt forgiveness would be matched by an equal tax. All local political pressure to implement eminent domain programs would cease.

A return of the tax could affect many of the nearly 10 million Americans who owe more on their loans than their homes are worth, according to the National Association of realtors (NAr).

In a short sale, if a property with a $400,000 mortgage sells for $250,000, the forgiven debt of $150,000 will be taxed after Jan. 1. The hit could top $35,000.

Gaining forgiveness of a $150,000 debt is still a huge windfall for a borrower. Paying a tax is a small price to pay.

This additional cost will complicate short sale negotiations. Ordinarily, holders of both the first and the second mortgages negotiate a deal for the borrower to liquidate some assets or get on a payment plan in exchange for debt forgiveness. Now with borrowers facing an extra debt to the government, these borrowers will have fewer resources they can pledge to their lenders.

Consumer advocates consider the tax unfair: “The money being taxed was ‘phantom income’ that existed only on paper,” said Elyse Cherry, CEO of Boston Community Capital, a non-profit, neighborhood stabilization group.

For Ponzis and HELOC abusers, that money existed in the real world, and they spent it with unbridled enthusiasm.

It will also damage foreclosure-prevention efforts, said Cherry. Many at-risk homeowners could not participate in programs if a big tax bill accompanies the fix.

“The program only works when we can save homeowners money,” she said.

Foreclosure prevention efforts that lead to short sale doesn’t serve the borrowers interest anyway. Who cares if they end up as foreclosures? Both short sale and foreclosure are distressed sales, and the occupant is no longer the owner when it’s over.

Eliminating the tax break for short sales encourages strategic default. Many borrowers will quit paying their mortgages to obtain the squatters benefit if they are denied a short sale. These borrowers will face a big tax bill even if they are allowed a short sale. They could probably pay lingering tax bills after a foreclosure by saving through squatting for several years.

With the tax back in place, short sales would be discouraged, according to former NAR president Gary Thomas. He believes extending this bill is critical to the ongoing recovery of the housing market.

[dfads params=’groups=165&limit=1′]Mr. Thomas may or may not believe extending the bill is critical to the housing recovery (smells like bullshit), but he certainly believes it’s critical to generating more real estate commissions (his real agenda). Short sales make realtors money; foreclosures don’t.

If it’s allowed to expire, many distressed homeowners may opt instead for continued default until foreclosure or simply to walk away from the property,” said Thomas.

Yes, they will.

“Either way, this would destabilize communities as foreclosed and vacant houses drive down values in the surrounding neighborhood.”

That’s a nonsense scare tactic. Short sales drive down prices just as much as REO, probably more so now that REO are so rare.

Chances of passing an extension before the year’s end seem slim, according to J.P. Delmore, an assistant vice president for government affairs at the National Association of Home Builders.

The best hope is that Congress will gets its act together sometime in 2014 and extend the tax break retroactively to the beginning of the year, he said. Even that may be a challenge, given the current climate in Washington.

Letting this tax break expire benefits lenders because it will keep supply off the market. Anything that benefits the banks eventually becomes policy in America.

Despite the benefit to the banks, I think letting this tax break expire is a good thing.

Did borrowers deserve this tax break?

The tax break was arguably a political necessity in 2007. Many innocent borrowers bought near the peak of the housing bubble simply due to their bad timing. Those borrowers who sold short on their purchase-money mortgages deserved a tax break; punishing them serves no public purpose, which explains why California gives those borrowers non-recourse status. However, the tax break was doled out to many who didn’t deserve it; Ponzis and HELOC abusers should pay taxes on the forgiven debt because those borrowers used the borrowed money as tax-free income. If legislators reconsider the expiration of this tax break, they should limit its application only to amounts less than the borrower’s original purchase-money mortgage. All mortgage equity withdrawal should be taxed as income.

How will the expiration of this tax break impact the housing market?

Fewer underwater borrowers will list their homes for sale if they must pay tax on the shortfall. The housing market suffered for the last two years with a shortage of MLS inventory. Many potential short sale listings were voluntarily removed from the market as lenders began demanding borrowers repay the shortfall. Rising prices gave many of these borrowers hope of an equity sale, so most hunkered down and hoped for the best. Now even if these borrowers get their bank to agree to take a loss, Uncle Sam is no longer amenable. This provides an added incentive for borrowers to keep their property off the market and wait until rising prices bails them out. I recently asked if 2014 will see the “Rise of the Short Sale”. With the expiration of this tax credit, the answer is no.

With fewer homes on the market, the balance of supply and demand will favor continued bubble reflation. In yesterday’s post, I discussed how the lower FHA loan limit will impact the market taking demand from one segment and concentrating it in another. This policy change will remove supply from all market segments. I believe this will be most noticeable in the under $660,000 market where demand will concentrate. Potential buyers can expect fewer offerings, and those available properties will be of lower quality. The plethora of properties priced above $660,000 will be tantalizingly out of reach.

The expiration of this tax break will keep more supply of the market. Low housing market inventory is our new normal.

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Should we give Ponzis a tax break?

The former owner of today’s featured property extracted over $250,000 in mortgage equity withdrawal from 2001 to 2006. That’s about $50,000 per year in extra spending money that was never taxed as income when they looted the bank. These borrowers undoubtedly spent that money just like they spent their wage income during that time. Money is fungible; wage income is indistinguishable from HELOC money. Why shouldn’t this money be taxed as income?

Two years in bank inventory

Some housing analysts contend lenders already disposed of their REO. Apparently, the servicer of the MBS pool that owns this REO didn’t get that memo. This property was auctioned on 11/9/2011; it spent the last two years hiding in the shadows. Based on the huge price rally over the last two years, the servicer made the right decision. They will recoup $100,000 more today than they would have two years ago. I doubt their carrying costs were that high.

[idx-listing mlsnumber=”OC13243720″]

180 South MYRTLE Ave Tustin, CA 92780

$499,900 …….. Asking Price
$329,000 ………. Purchase Price
5/18/2001 ………. Purchase Date

$170,900 ………. Gross Gain (Loss)
($39,992) ………… Commissions and Costs at 8%
$130,908 ………. Net Gain (Loss)
51.9% ………. Gross Percent Change
39.8% ………. Net Percent Change
3.3% ………… Annual Appreciation

Cost of Home Ownership
$499,900 …….. Asking Price
$17,497 ………… 3.5% Down FHA Financing
4.52% …………. Mortgage Interest Rate
30 ……………… Number of Years
$482,404 …….. Mortgage
$136,649 ………. Income Requirement

$2,450 ………… Monthly Mortgage Payment
$433 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$104 ………… Homeowners Insurance at 0.25%
$543 ………… Private Mortgage Insurance
$0 ………… Homeowners Association Fees
$3,530 ………. Monthly Cash Outlays

($644) ………. Tax Savings
($633) ………. Principal Amortization
$29 ………….. Opportunity Cost of Down Payment
$145 ………….. Maintenance and Replacement Reserves
$2,427 ………. Monthly Cost of Ownership

Cash Acquisition Demands
$6,499 ………… Furnishing and Move-In Costs at 1% + $1,500
$6,499 ………… Closing Costs at 1% + $1,500
$4,824 ………… Interest Points at 1%
$17,497 ………… Down Payment
$35,319 ………. Total Cash Costs
$37,200 ………. Emergency Cash Reserves
$72,519 ………. Total Savings Needed
[raw_html_snippet id=”property”]