The debt forgiveness tax break should not be extended

Ordinarily, if a borrower has debts forgiven outside of a bankruptcy, the amount of the forgiven debt is taxable income. This makes perfect sense if you think about it. If one party gives another money, it is either a gift or it’s income. Even if it’s a gift, if it’s over a certain threshold, the government taxes it as income, largely to prevent wealthy people from avoiding inheritance taxes.

When a borrower gets a large amount of money from a lender, it’s not income because the money is repaid. If it isn’t repaid, it’s either a gift or it’s income. Anyone who received debt relief from a lender between 2007 and 2012 was able to treat the money as a gift. It was truly free money. There’s no good reason we should be subsidizing those receiving these free-money gifts from lenders, but if we hadn’t, the overhanging tax bills would be dogging debtors for years. For as much as I would like to see that happen to Ponzis, it’s not a fate commensurate with the crime of those who simply timed the market poorly.

Like many others, I assumed this tax break would be extended in perpetuity.  There are a number of other consequences to individuals and the entire housing market. If it isn’t extended, it will force many people into bankruptcy. Also, anyone who signed up for a loan modification rather than a short sale or strategic default had better keep paying. The consequences of short selling or defaulting later will be much more severe. A great many loanowners signed up for loan modifications under HAMP 2.0. Most of those modifications will at least make it into 2013 before they implode or otherwise need to sell. With no tax forgiveness on a short sale, even fewer people will be able to sell their homes which will exacerbate the inventory shortage we have today.

Housing Alert: Short Sales May Be in Big Trouble

CNBCBy Diana Olick | CNBC — 9/28/2012

As lenders plow through a backlog of over five million delinquent mortgages, short sales are becoming an ever more popular escape route. A short sale is when the bank allows a home to be sold for less than the value of the mortgage. The bank takes the loss, but that loss is generally less than a more costly foreclosure.

While prices were going down, lenders often lost less on short sales, but once prices begin to rise, the opposite will be true. Short sales take much longer to complete that REO sales after a foreclosure. Both may go into escrow with a similar market discount, but when prices are falling, the longer duration of a short sale means it sells for more relative to comps at the time of sale. In a time of rising prices, the short sale discounts get deeper as time goes on causing a loss even larger than an REO.

The government has been pushing more short sales at Fannie Mae and Freddie Mac through financial incentives, and banks are streamlining the process. Short sales have been gaining so much steam, they actually surpassed sales of foreclosed properties last spring, according to LPS Applied Analytics’ Home Price Index. But all the progress that has been made could end abruptly.

A short sale is debt forgiveness. Debt forgiveness is taxable. In order to help the huge volume of troubled borrowers and promote more short sales, Congress in 2007 passed the “Mortgage Forgiveness Debt Relief Act and Debt Cancellation.” The debt forgiveness from a short sale or a mortgage principal reduction would no longer be taxable. That act is part of many Bush era tax cuts that expire at the end of this year. Without an extension, short sales would grind to a halt, as might mortgage modifications that involve principal reduction.

Is that a realistic scenario? It will certainly make it less desirable to short sell. It will likely prompt more strategic default as many who would like to sell either stop paying and move on, or they stop paying and squat until foreclosure. If there is a tax consequence either way, the greater benefit comes from squatting until foreclosure, particularly if prices are rising and they end up owing less tax if they wait.

I foresee some epic challenges over the junk fees lender pile on to delinquent loans. Many people believe they walked away from $50,000 to $100,000 in debt only to find out later the final amount was closer to $250,000 because the lender tacked on late fees, lost interest, service fees, and other foreclosure expenses. The tax bills will be much, much larger than many anticipate.

“Realtors believe if the legislation is not extended, households who are already struggling to pay their mortgages will be further burdened with tens of thousands of dollars in additional taxes that they probably can’t afford to pay because the IRS would count the cancelled debt as income,” said Jamie Gregory, a lobbyist for the National Association of Realtors.

With the tremendous benefit these people are getting with the debt forgiveness, I can’t feel too sorry for their tax “burden.”

Short sales and mortgage principal reduction are the foundation of the $25 billion mortgage servicing settlement signed early this year by the nation’s largest lenders and state attorneys general. As of the end of August, first lien principal reduction trial modifications were offered and begun for about 28,000 homeowners, totally approximately $3 billion of potential relief, according to the settlement monitor, Joseph A. Smith. Banks have granted $10.6 billion in consumer relief, which would include short sales. More than a quarter of a million short sales were completed in the first half of 2012, according to RealtyTrac.

One of the reasons our inventory is so low is because many pending short sales were approved once lenders go credit for these under terms of the settlement.

So what is the possibility of congress extending the tax relief? One Hill-watcher puts it at 60-40. The Senate Finance Committee passed a package of tax extenders right before the recess, including a one year mortgage relief extension, but leadership in the House of Representatives has not figured out how it wants to handle these extenders. With the looming “fiscal cliff,” tax cuts are an increasingly tough sell. This particular extension does have bipartisan support, but that doesn’t always mean passage in Congress, especially around a presidential election.

I wrote about the difficulties of the upcoming tax debate in Will rising taxes force housing over the fiscal cliff. I would be pleasantly surprised if this tax break were not extended.

“It could be an uphill fight to get this passed this fall, as it will likely get caught up in larger debate of over taxes, deficits and the financial cliff. But we believe that it is a helpful provision for distressed borrowers, as getting a tax bill on forgiven debt can be another punch in the gut for families who are already facing financial hardship,” says David Stevens, president and CEO of the Mortgage Bankers Association.

Rep. Jim McDermott (D-WA), who introduced legislation last March to extend the tax relief for three years said in a release, “Collecting federal income tax on relief intended for struggling homeowners is not only bad policy, but is simply wrong.”

No. Giving tax relief to millions who foolishly overextended themselves is simply wrong, particularly for the Ponzis. I could endorse a tax forgiveness on purchase-money mortgages even though some of those people foolishly over-borrowed because many victims of bad timing would be helped. I can’t endorse any tax break for Ponzi borrowers who tapped their home equity to fuel consumer spending. What possible justification is there to give Ponzis a subsidy?

With great uncertainty as to the fate of the tax relief, some say short sales could get a boost this fall. Borrowers and banks alike may rush to get in before the expiration, which could help boost overall home sales numbers.

I don’t think that is going to happen. If they haven’t listed it yet, there probably isn’t time to complete the short sale before the end of the year anyway. If this tax break isn’t extended, the chronic shortage of MLS inventory will continue, and people who sell short or obtain relief in the future will be really hosed. I suspect large numbers will fail to report these taxes and take their chances.