By David Dayen, a lapsed blogger, now a freelance writer based in Los Angeles, CA. Follow him on Twitter @ddayen
The IRS settles something I noticed a while ago and has now been finally confirmed. In short: big banks who robbed homes from Americans got a penalty that entailed, quite literally, giving homeowners worthless allowances.
The issue concerns the Mortgage Forgiveness Debt Relief Act, which expires at the end of the year. After December 31, all mortgage relief that involves debt forgiveness of any kind will be taxable to the borrower. This affects principal reductions, of course, but also short sales, with the idea being that this involves the bank “forgiving” the difference between the total owed on the mortgage and the price of the short sale. There are hardships exemptions to this but they involve the functional equivalent of bankruptcy – you have to prove that your total liabilities exceed your total assets.
Sen. Barbara Boxer wrote the IRS asking for a clarification about short sales in non-recourse states, like her home state of California. If a state is non-recourse, the bank cannot go after a foreclosed borrower post-foreclosure sale for a “deficiency judgment,” seeking money from that borrower if the sale price comes in lower than the price of the mortgage. This also has application for a short sale; technically speaking, in a non-recourse state the short sale is just a waiver of a deficiency judgment. So Boxer wanted to know whether Californians, in a non-recourse state, could still do short sales and not be subject to a tax on the debt relief, even if the Mortgage Forgiveness Debt Relief Act expires. Because, the theory goes, it’s not really a debt relief at all, since the bank cannot go after a California resident for the balance anyway.
The IRS replied to Boxer by affirming her theory:
Homeowners who live in states where mortgages are non-recourse—that is, where they aren’t personally liable for the unpaid balance—may avoid the potential tax hit even if Congress doesn’t act, according to a letter sent by the Internal Revenue Service released by Sen. Barbara Boxer (D., Calif.) on Friday [...]
In the letter to Sen. Boxer, the IRS clarified that certain non-recourse debt forgiven by lenders wouldn’t typically be considered taxable income by the IRS. This means that for most California borrowers, the expiration of the tax provision may not have a meaningful effect [...]
In the letter, the IRS wrote that “if a property owner cannot be held personally liable for the difference between the loan balance and the sales price, we would consider the obligation a non-recourse obligation.” As a result, the owner would not have to count that forgiven debt as income.
Here’s the letter to Boxer, which actually dates back to September but which I’m just hearing about now.
Here is why this is important, aside from Californians being spared from getting hit with a tax bill on a short sale. The Justice Department, in the National Mortgage Settlement, allowed short sales in non-recourse states to count toward the penalty the five biggest mortgage servicers “paid.” If the IRS says something is not a thing of value, it’s not a thing of value. The borrower would not be liable to make up the difference of the mortgage after a short sale anyway in a non-recourse state. The servicer didnt “forgive” anything. So the banks got away with paying off their penalty for a series of crimes with completely worthless non-recourse short sales. That’s the implication of the IRS letter.
Think this doesn’t matter? It’s not just applicable to California, but any non-recourse state. There are 12 of them, as I found out when I researched this situation over a year ago. And as of last August, as I wrote, the majority of short sales counted under the settlement were going to non-recourse states, where the servicers had no ability to recoup mortgage balances anyway:
What we’re saying in that instance is that banks are given credit for paying a “penalty” by not collecting the balance of a mortgage after the sale, something they are PROHIBITED BY THE STATE FROM DOING.
And guess what? The OMSO report breaks this down by state. So I can see that the five big banks participating in the settlement got credit for $522 million in short sales in Arizona and a whopping $3.9 BILLION in California. Those two alone equal over half of the total short sales in the report. If you total up all the non-recourse states (I’ve put their raw totals at the end of this piece), you get over $5 billion in short sales coming from states that bar banks from pursuing a deficiency judgment.
This is a handout to the banks. Some part of this $5 billion will satisfy their punishment in the settlement (not all of it; there are portions of a dollar in the formula based on where the loan was held in portfolio or was a securitized loan held by an investor). And it represents $5 billion these banks could never collect, $5 billion they’re barred by collecting by law. Banks should never have been allowed to count deficiency judgment waivers or short sale forgiveness in non-recourse states. But they are, and they’re doing it in big numbers.
That was as of last August. Here are the most recent numbers, through the end of June 2013, compiled by the Office of Mortgage Settlement Oversight. Over $12 BILLION in short sales went to non-recourse states, now described by the IRS as worthless for the borrower, because the bank is already prohibited by law from collecting any of the debt it “forgave” in those states. That’s out of a total of $20.9 billion in short sales counted in the settlement, so well over half came from non-recourse states. The breakdown here:
North Carolina: $145,747,252
North Dakota: $1,190,321
In general, servicers got 45 cents on the dollar credit for short sales, though 20 cents on the dollar for short sales on investor-held loans and 100 cents on the dollar for extinguishing second liens in a short sale (see section D-1 here). Also the non-principal reduction credit was capped at $7 billion of the $17 billion. Without knowing everything about the loans it’s hard to know exactly how much credit banks got for worthless non-recourse short sales, but given that short sales are a healthy portion of the top-line, un-weighted consumer relief number that the Administration likes to throw about – here’s Obama using it just three months ago – We can safely say that over $12 billion of the $50 billion in “consumer relief” that was supposed to be a penalty for misconduct has been shown by the IRS to be totally worthless. That’s close to 1/4 of the total.
The entire mortgage settlement was a rotten scam, but we can say that unreservedly in the case of 25% of it.
POSTSCRIPT: I recognize that life is slightly better for a borrower after a short sale than after a foreclosure, with the main benefit being a slightly lesser hit to their credit report. But first, the mortgage settlement was allegedly designed to keep people in homes, not help them marginally with being kicked out. And in this case, I’m looking at the nature of the penalty for the banks, not the effect for the borrower. And clearly the penalty is worthless.