I have a piece in Salon about an under-the-radar issue I’ve discussed here before. Here’s a long excerpt:
The letter from Bank of America Home Loans got right to the point. “We are pleased to inform you that we have approved your Home Equity Account for participation in a principal forgiveness program offered as a result of the Department of Justice and State Attorneys General global settlement with major mortgage servicers.” In the letter, which I obtained from an anti-foreclosure activist, Bank of America offered the homeowner full forgiveness of their entire home equity loan balance of over $177,000. But then Paragraph 5 came with an ominous warning: “Please be aware that we are required to report the amount of your cancelled principal debt to the Internal Revenue Service.”
Under current law, a principal reduction like this would be exempted from tax liability. However, that law, the Mortgage Forgiveness Debt Relief Act, expires at the end of the year, and after that, any mortgage debt forgiveness provided to a borrower will count as gross income for tax purposes, potentially costing millions of families several billion dollars. In the above case, the borrower would be required to pay taxes on the entire $177,000 amount forgiven by the bank, as if it were earned income. And that’s money that struggling homeowners simply don’t have.
“They wouldn’t be able to handle it,” said Peggy Mears of the Alliance of Californians for Community Empowerment, a community organizing group in California that has worked extensively on foreclosure issues. “If they could handle it, they wouldn’t be in arrears with their house notes. They don’t have that kind of money.”
The tax issue could significantly disrupt a still-fragile housing market and rob homeowners of the tools to pull themselves out of mortgage debt. It also represents a final indignity for homeowners who have been abused by the fraudulent mortgage practices of leading banks for years. Just when they think they get relief from their troubles, they get hit with a massive tax bill they cannot pay. “This has the effect of pulling people up with one hand, and hitting them in the face and knocking them over the cliff with the other,” said Sen. Jeff Merkley, D-Ore., who supports extending the law.
I wanted to add some more context that I wasn’t able to fit in a very long piece.
• The “compensatory damages” issue: There are two bills in Congress trying to fix this. One just extends the debt forgiveness tax relief for two more years, at a cost of $2.7 billion. That is actually part of a tax extenders package that the Senate Finance Committee will mark up today, though Republicans are trying to excise it. The broader bill, in the House from Rep. Jim McDermott, would also exempt awards from the settlement, like the $2,000 checks for foreclosure victims, or the large cash awards for violations of the Servicemembers Civil Relief Act (well over $100,000 in most cases). The authors of the settlement never made it explicit that the awards were compensatory in nature, which would have accomplished two things. One, it would have made the awards tax-exempt. Two, it would have disallowed banks from deducting the awards on THEIR taxes. Without that language, it’s unknown how the IRS will react. So that’s just another little backdoor bailout. The McDermott bill would both exempt the direct cash awards and disallow deductibility for banks.
• The “Form 982″ issue. Someone at Salon alerted me to the fact that, even if the law doesn’t pass, there’s an opportunity for homeowners to get an exemption from paying taxes on their debt forgiveness, be it from a principal reduction or a short sale. If you qualify under an insolvency standard, you can get out of the tax. Here’s the FAQ at the IRS site:
The forgiven debt may qualify under the insolvency exclusion. Normally, you are not required to include forgiven debts in income to the extent that you are insolvent. You are insolvent when your total liabilities exceed your total assets. The forgiven debt may also qualify for exclusion if the debt was discharged in a Title 11 bankruptcy proceeding or if the debt is qualified farm indebtedness or qualified real property business indebtedness. If you believe you qualify for any of these exceptions, see the instructions for Form 982. Publication 4681 discusses each of these exceptions and includes examples.
The borrower must then petition for exclusion under this insolvency standard by filing Form 982. But it’s actually no guarantee. If you have a car, the fair market value of the car would count. If the principal forgiveness gives you equity, it’s unclear whether or not that equity would count. People can have illiquid assets and be cash-poor. And in short sales, this could particularly be the case, such as if a homeowner is moving for a job, and negotiated the short sale to get out of an underwater home. I can think of plenty of examples where the homeowner wouldn’t qualify. The issue is serious enough that people in Congress (people on the good side of things, in this case) are trying to fix it. And that’s because it’s damn hard for people with no accounting experience and no ability to hire an experienced CPA to navigate the Form 982 process.
I mean, the tax is also exempted if the debt is discharged in bankruptcy. I don’t think we want to encourage that.
The real problem is the logistical nightmare of going through an audit, as well as knowing about the reporting issue in the first place. Even under the Mortgage Forgiveness Debt Relief Act, you have to file Form 982 and check the box that explains the debt relief is excluded because it was the “discharge of qualified principal residence indebtedness.” This has tripped up many homeowners, who simply didn’t know they had to report the exclusion. So I see it as very much a live issue.
• Where is everybody? Since Ed DeMarco rejected the use of principal reductions on Fannie and Freddie loans, I’ve been getting a steady stream of complaints from liberal groups and housing advocates. Just to pick a couple at random: “By ignoring his own agency’s analysis Acting Director Ed DeMarco has undermined the health of the housing market, and jeopardized the economic security of our middle class,” Nancy Pelosi said in a statement. “Resetting the mortgages of America’s 15 million underwater homeowners could save the taxpayers billions of dollars, create jobs, and restore the dream of homeownership that was shattered by Wall Street recklessness,” said the Home Defenders League.
But nobody has said a word about this tax issue. Some of those I talked to for the story even admitted their inattention. You can have Marco Rubio put out a press release about ensuring that Olympic medals are exempted from taxation, and get all kinds of articles on it, but not one major newspaper has uttered a word on this. And the New York Times, Wall Street Journal et al. have been covering the principal reduction issue with precision.
I wrote this piece, outside my normal bubble, to get some awareness. This is a serious issue that could potentially affect millions of families. Housing advocates need to get in the game.