The Mortgage Forgiveness Debt Relief Act of 2007

In previous post, “Do not trust a Realtor's® advice on short sales," I discussed the tax implications of short sales. Under current IRS regulations, troubled homeowners who complete a short sale could face a large tax bill. Typically, taxpayers will have to recognize any forgiven debt in the short sale as ordinary income.

In the comments to one of my posts yesterday, a reader asked if any progress had been made on, H.R. 3648, The Mortgage Forgiveness Debt Relief Act of 2007. The reader also provided a great link to Mish’s Global Economic Trend Analysis site that explains the the legislation:

“The legislation would provide relief to those families by permanently excluding debt forgiven under these circumstances from tax liability. Prior to this legislation, forgiven debts were added to a person's tax liabilities as ordinary income. For example, if a person walked away from a home owing $100,000 more on a house than the foreclosure sale proceeds and that debt was forgiven by the lender, the IRS considered that $100,000 as ordinary income and expected taxes to be paid on the amount of forgiveness. This proposal is estimated to cost $1.379 billion over 10 years.”

Last week, on September 26, 2007, the House acted:

“The House Committee on Ways and Means unanimously approved H.R. 3648, the Mortgage Forgiveness Debt Relief Act of 2007, today in response to some of the tax issues that have arisen as a result of problems in the subprime mortgage market. Under current law, debt forgiven following mortgage foreclosure or renegotiation is considered income for tax purposes, resulting in tax liability for individuals and families.”

“The legislation advanced by the Committee today would provide relief to those families by permanently excluding debt forgiven under these circumstances from tax liability. The bill would also help would-be homeowners secure their investments through a long-term extension of the tax deduction for private mortgage insurance, and would ease restrictions for qualifying as housing cooperative corporations. Finally, the bipartisan bill would tighten requirements taxpayers must meet to exclude gain from the sale of certain homes that have been used as a vacation home or rental property.”

Who will this benefit?

While this is still long way from becoming law, I think this piece of legislation is both fair and absolutely vital. Some of the reasons, I think this is great legislation includes:

1) Taxing individual taxpayers at a time when they can least afford it seems ridiculous. Furthermore, the way the current tax law is written, troubled homeowners are encouraged to choose bankruptcy and foreclosure over a short sale in order to avoid the tax. A short sale relative to bankruptcy is much less destructive to credit, costs the taxpayer little, and does not clog our legal system

2) While the individual taxpayer benefits from this bill, it also receives support from the National Association of Home Builders, the National Association of Realtors® and the Mortgage Broker Association. All three benefit from short sales over foreclosure.

3) The bill has some provisions to protect against those who “game” the system. For instance, the provisions of this bill would only apply to “home-acquisition debt.” It would not apply to “home-equity debt.” In other words, your neighbor who used a HELOC to purchase a Hummer, a 72” flat-screen television, and a new 25-foot center-console fishing boat, will not benefit.

It also will not help flipper or speculators because only principal residences would apply.

Furthermore, the bill, which will cost $1.4 billion, will be paid for by cutting out a another significant loophole. A Mercury News blog explains:

“But the more interesting thing about this bill is how it would offset those lost revenues by taking aim at a tax gambit promoted to wealthier taxpayers who own vacation homes or rentals. Those folks are likely to pay $2 billion more in taxes from 2008 through 2017 if this legislation becomes law.”

“Under current rules, single homeowners generally can shelter up to $250,000 of capital gains when they sell, while couples can shelter up to $500,000. The main condition: They must live in the house for two of the five years leading up to the sale.”

“This presents an opportunity for homeowners to shelter a lot of gains on several properties by living in each of them for two years. For example, a couple could sell their principal home in Sunnyvale, pocket $500,000 in capital gains, and move into a rental or vacation home. Two years later, they could sell that property and exclude gains of up to $500,000.”

“Uncle Sam wants to clamp down on a loophole that enables wealthier taxpayers to shelter gains from rental properties and vacation homes by briefly treating each of them as ‘principal’ residences.”

Basically, this bill, if passed in its current form will cost taxpayers nothing.

4) The bill benefits those taxpayers that must pay for private mortgage insurance (PMI):

“The bill extends the deduction for private mortgage insurance for seven years (through the end of 2014). Current law limits the deduction for private mortgage insurance to payments made prior to the end of 2007. The bill would provide that payments will qualify for this deduction whenever they are paid so long as the contract is entered into after 2006 and before 2015.”

How will this affect our local market?

I think one reader put it best, “If it passes in its current format, it could encourage more upside down property owners to give the keys to the bank and walk away.”

Still, a quote from the National Association of Homebuilders (NAHB) could lead one to believe that this will y result in more debt restructuring in lieu of short sales or foreclosure:

“The existing tax rules encourage many struggling homeowners (specifically those in states with non-recourse debt as the primary mortgage model) to seek foreclosure over restructuring their loan with lenders. This moves more homeowners out of their homes, destabilizes neighborhoods and increases the inventory of the housing stock on market. Second, the potential increase in tax liability discourages homeowners who are solvent from seeking restructuring agreements from lenders, a preferred situation for all involved. H.R. 3648 would encourage market-based restructuring between lenders and homeowners and discourage foreclosures.”

In context to this bill, the NAHB is not talking about interest rate reductions because changes in payment terms are not taxable -- only reductions in loan balances are taxable. Still, I cannot imagine that many lenders will simply reduce loan balances on borrowers and allow them to stay in their homes. If they did that for any homeowners, then lenders would be flooded by debt forgiveness requests from homeowners claiming insolvency.

In the end, I think passage of this bill will accelerate the flood of inventory that many of us are expecting as outstanding ARMs reset. With no tax liabilities, most troubled homeowners will jump at the chance of getting out of their mortgages.

In addition, even those who can afford their mortgage payments will take steps to qualify for short sales. After all, wouldn’t you try to short sell your home if it was worth a fraction of your outstanding mortgage, especially if there were no financial consequences other than some short-term blemished credit?

In my opinion, the continued flood of inventory is inevitable; this will just accelerate it.

What do you think?