According to the latest report from Zillow, nearly 11 million homeowners have negative equity in their homes, or are considered underwater. That’s more than the population of 43 of our states: only California, Texas, New York, Florida, Illinois, Pennsylvania and Ohio can boast census numbers larger than that figure. The rate works out to about in five homeowners with a mortgage (if you add in those homeowners with 20% or less equity in their homes, called the “effective” negative equity rate, that number doubles to two in five homeowners). By the dollars, homeowners in the U.S. were underwater by $805 billion as of the end of third quarter of 2013.
The good news is that number is shrinking. Last year at this time, nearly one in three homeowners with a mortgage were underwater. The dip seems to indicate that the housing market is continuing to recover – or correcting, depending on who you ask – from the subprime mortgage crisis in 2007.
That crisis, which either contributed to or resulted from the 2007 recession (again, depending on who you ask), burst the housing bubble, sending many homeowners scrambling to unload properties. With a glut of overpriced homes on the market, real estate was slow to move, making sales difficult and often painful for homeowners. Sometimes, the result was renegotiated mortgage or a short sale. Other times, homeowners simply walked away with no home but also no debt. Only there was a bit of a catch. For federal income tax purposes, once a lender writes off any part of your debt – even a mortgage – that amount which is forgiven is reported to the Internal Revenue Service on a form 1099-C. That amount may be includable as income. The result? No money. Possibly no home. And potentially serious tax debt.
To try and stop the bleeding, Congress passed the Mortgage Forgiveness Debt Relief Act in 2007. The Act, which offered an exception to the debt as taxable income rule for qualifying homeowners, was signed into law by President George W. Bush at the year end. It was intended to be retroactive, beginning with January 1, 2007, and applied to mortgages discharged through December 31, 2009. But recovery didn’t come quickly enough so the Act was extended in 2008 for another three years, through December 31, 2012. And when recovery still didn’t come quickly enough, the Act was extended through December 31, 2013.
There are, however, three bills in Congress right now that would extend the Act yet again. The Senate’s version of the bill, S. 1187, sponsored by Sen. Debbie Stabenow (D-MI) would add another band-aid to the wound, extending relief one more year. That bill has been referred to the Committee on Finance, where it has remained since June 19, 2013. Both House versions of the bill would also extend the Act for one more year. Similarly, both versions remain in committee.
The question of what to do with the Act is not easily addressed.
From a revenue perspective, one argument against extending the Act is that it depresses revenues by exempting otherwise taxable income from collections. Critics argue the lost revenue argument is flawed since those who can’t afford to pay their mortgage would not be able to pay the tax on the debt forgiveness.
Housing advocates argue that not extending the Act is simply bad policy, punishing those already facing serious financial difficulties and pushing off a potential recovery in the housing market. Others question whether any such recovery is going to happen, suggesting that the market simply “right-sizing.” It has, after all, been seven years since the law went into effect and while the numbers of underwater homeowners are falling, they are not falling quickly enough to make a significant difference.
I’m not a fan of extending the Act. My objection isn’t so much a revenue issue, nor is it a housing advocacy or market issue, but rather a tax policy note. I agree that it isn’t sensible to ask strapped taxpayers to pay up on what is essentially phantom income. But Congress had already anticipated this concern in years prior, just not restricted to home ownership. Under existing tax law – even without the Mortgage Forgiveness Debt Relief Act – there is an insolvency exclusion. Under the exclusion, if you are insolvent when your debt is cancelled, some or all of the cancelled debt may not be taxable to you. You’re considered insolvent when your total debts are more than the fair market value of your total assets.
I get that “total debts” and “total assets” aren’t necessarily restricted to mortgages and home ownership. But the underlying theme – that you shouldn’t be forced to pay taxes when you can’t pay your other debts – is the same, no matter what kind of debt. And, in fact, before 2007, taxpayers who found themselves underwater (and yes, it did happen before 2007), relied on the insolvency exclusion for protection when applicable: you can still opt to claim the insolvency exclusion on a mortgage when you don’t meet the criteria for the mortgage exclusion. The same insolvency rule applies to the discharge of other debts, too, like car loans, student loans and credit cards.
But let’s say that we decide that homeowners should be, as a matter of policy, protected from paying tax on the cancellation of mortgage debt even when the insolvency exclusion doesn’t apply. If that’s true, why keep putting a band-aid on it? Why stop with one year? Why not five years? Or ten years? Why not make it a permanent exclusion? At what point is constantly extending the Act by one year increments just more than a bit silly?
I agree that we’re not out of the woods in the housing crisis. Or the jobs crisis. Or the student loan crisis. The economy is clearly not fully recovered (despite what is apparently a healthy day on Wall Street today). But it seems to me, however, that our current tax policy isn’t helping us out of the crisis. We need long-term solutions, not last minute throw togethers.
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