Will Expiration of Tax Break Render Much of Mortgage Settlement Moot?

Even though the mortgage settlement deal was without a doubt massively lawyered from the bank end, and should have received similar levels of scrutiny from the Federal and state officials, a major fly in the ointment may have been overlooked. The tax rule allowing a reduction in mortgage debt not to be counted as income expires at the end of this year. As the Seattle Times explains (hat tip Lisa Epstein):

Before 2007, all cancellations of debt by creditors — whether on auto loans, personal loans or mortgages — were treated as taxable events under the federal tax code. If you owed $200,000, but paid off only $150,000 through an agreement with the lender, the $50,000 difference would be ordinary income, taxable at regular rates.

Under the debt-relief law for qualified homeowners, you can avoid taxation on forgiven mortgage amounts up to $2 million if married filing jointly, or $1 million for single filers. To be eligible, the debt must be canceled by a lender in connection with a mortgage restructuring, short sale, deed-in-lieu of foreclosure or foreclosure. The transaction must be completed no later than Dec. 31…

Picture this scenario: You negotiate for months with your lender, realty agents and potential buyers. Finally you pull together a short-sale package calling for the bank to forgive $100,000. But the deal runs into hitches and doesn’t go to closing until after the Dec. 31 expiration date. Now your house is gone, your credit is shot, you’re looking for a place to rent, and the IRS demands taxes on your phantom “gain” of $100,000 on the sale.

The Seattle Times article estimates the odds of renewal of this program at less than 50%, since Republicans claim a two-year extension would cost $2.7 billion and would help deadbeats.

Consider how this interacts with the mortgage settlement deal. $10 billion of the total headline amount of $25 billion is to come from mortgage mods, which the Administration expects to come to a much bigger number in actual value, since banks are expected to get a credit of only 50% for mods of securitized mortgages. Since the Administration estimates that 85% of the mods would be on mortgages not on bank balance sheets, that would give a total value of $18-$19 billion. Another “up to $7 billion” is for “forbearance of principal for unemployed borrowers, anti-blight measures, short sales, and transition assistance.”

Look at the timetable. The mortgage deal is supposed to be finalized by the end of the month and submitted to court for approval by a Federal judge. We have been told the great unwashed public won’t see the actual terms prior to its submission. Given that various press leaks have indicated that some items are less nailed down than the officialdom would have your believe, there is good reason to think the court filing will come after the planned date of the end of this month.

Let’s assume the filing is made by the Ides of March. Since there is not a precedent for this sort of deal, I would hope the judge would allow for an adequate amount of time for interested parties to submit amicus briefs on the filing. The Administration, of course, will press for fast track approval. Let’s assume 60 days from a mid March filing, so mid May approval. The banks are given three years to accomplish the required principal mods, with 75% to take place in the first two years. Let’s assume the other $7 billion is on the same timetable.

If the banks are to be on track for their 75% in two years, you could expect them to do 37.5% in the first year. That’s actually likely to be generous, since they’d be ramping up in the first year, plus it will take time to get any mod or short sale done (the article said that short sales take four to twelve months).

Take (7.5 months/12 months)N x 37.5% and you get less than 25%. So the bank are likely to be at the very best a bit over 20% of the way though their required mods and other forms of relief, and given start-up and lead time factors, may be well below even that level.

What happens as of December 31? What borrowers will remain interested in short sales and principal mods if they will be hit with large tax bills? The benefit of the mod will take place over time, but the adverse tax consequences will be immediate.

With the old tax rules in place, foreclosure is likely to wind up being the least bad of poor choices for most underwater borrowers who are under financial stress. Even if they would like to reduce the damage to their credit record via a short sale, the tax consequences may make that unaffordable.

And what does this mean for the banks? A substantial portion of the value of the settlement was to come in the form of mortgage mods and short sales. Even though the banks are supposed to be liable for the dollar amount in the settlement, what happens if they can legitimately argue that demand for principal mods and short sales has evaporated thanks to the expiration of tax relief? Is there any penalty or Plan B in the deal if the banks fail to produce the required level of mortgage modifications? I have a sneaking suspicion that this scenario is not reflected in the pact, and it gives the banks a perfect excuse for underperforming on an agreement that was already badly skewed in their favor.

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  1. LeonovaBalletRusse

    They’ve thought of everything in their favor, haven’t they?

    RE: “won’t see the actual terms prior to its submission” — a comment link to a ZH blog last evening (2/21/2012) led to the actual document showing the *arrangement* the Troika struck with Greece. Like with the *mortgage settlement*, the parties have *agreed* to something not yet finalized. It’s like signing a contract that has not yet been written, to which your are bound by your signature at the bottom of the (phantom) contract.

    This must be the *new new thing*.

    1. PQuincy

      Emperor Sigismund of Luxembourg was deposed early in the fifteenth century in part for issuing blank but imperially sealed charters to his friends — at least, that’s what the indictment said. How is this different?

  2. psychohistorian

    I somehow see this ploy as a form of can kicking by the US just like the EU and its contrived Shock Doctrine event around austerity.

    As long as everyone keeps believing and the music keeps playing then it continues to be Game On! Mankind is not suffering enough yet.

    Tax breaks, like those for the rich, and this sort of double jeopardy for principal adjustments are just more examples of our current anti-social organizational structure. I continue to think that if we removed the global inherited rich from control we would find improving our world much easier.

  3. Rotter

    This plays out over and over and over these days in the new politics of lies and illousions. NONE of these people are credible. There-is-no-one-on-the-inside- who can be trusted, and if they can be, they are secretly working to bring it down and we wont know about them anyway. This jerk will probably run for senate under the banner of the jackass party, a-la Elizabeth Warren, “the reformer”.

  4. Jim A.

    It is difficult to make people understand why they should pay taxes on forgiven debt. They HAD the money(albiet briefly). They spent it. Now they don’t have to pay it back. There’s some sort of cognitive dissonance when people look at what is for them a huge ammount of money like the purchase price of a home (or even a car). They just can’t concpetualize it EXCEPT as a series of monthly payments. So they don’t realize that at some level they have spent the entire purchase price of the house. Paying back their debt to the bank is a separate thing, especially in a full recourse state like mine.

    1. F. Beard

      It is difficult to make people understand why they should pay taxes on forgiven debt. Jim A.

      No it’s not. If people can’t pay their debts then how in the heck can they pay their taxes?!

      Plus, in the case of a monetarily sovereign government such as the US, taxes are not necessary to fund expenditures in the first place.

      1. hcm1

        Cancellation of debt incurred to purchase a home is treated as an adjustment to purchase price, not as taxable income. Cancellation of refinanced debt or home equity loans not used for home improvements would be treated as taxable income. From a tax law perspective this generally makes sense but there can be some anomalies. For example if a debt is modified significantly it may be treated as a new loan.

        1. Jim A.

          Okay, that would change it from income to a capital gain. But as pointed out by others, if you’re insolvent it doesn’t really matter.

        2. Jim A

          Is that true even for full recourse debt? Certainly in MD and FL mortgages are full recourse. Notwitstanding the fact that lenders don’t usually exercise that right, the fact that they CAN may have legal implications.

        3. Yves Smith Post author

          No, read the article. A mod in EITHER case is treated as loan forgiveness. Same is true of credit card debt, if you call your bank and negotiate a reduction (which you can if you can convince them if you are really broke and will default anyhow).

          You are confusing foreclosures v. mods. In a FC, there is no tax penalty whether a refi or a purchase money mortgage. The bank took the house to satisfy the debt, so the fact that you lost the house takes the IRS out of the picture.

  5. Slade Smith

    I’m not 100% sure on this, but I believe that at least some principal reductions in some “non-recourse” states may not be subject to this tax, even if the tax break were allowed to expire, since non-recourse debt which is forgiven would still not be subject to the tax.

  6. Bravo

    “We need a common sense approach in order to get this economy running again.”

    How about applying all the political pressure possible to junk the alleged settlement, save for the robosigning penalties, and instead set up State Title Courts that give local judges the hammer to impose rational loan modifications in cases where chain of title has in fact been compromised. In those cases, give them the authority to write down 1st and 2nd liens to current property market value. In return, a borrower is incented to choose not to strategic default, and cooperates in executing new loan docs that secures the MBS investor 1st lien and helps the servicer clean up the chain of title problems the securitization monster created.

    Let the 1st and 2nd lien holders and the borrower then attempt to recover some of their losses collectively by splitting appreciation of the home over a new 10 year loan term, 30 year amortization, set at a current market rate of interest. If servicer can prove to the court there is no chain of title issue, then the borrower has to pay up or consent to a deed in lieu. if the chain of title problems are not as widespread as the banks would have you believe, how could they defend their prospective opposition?

    There are plenty of capable, truly independent forensic audit firms out there that could be engaged by the State Title Courts to do the audit work, the cost of which could be paid for by the banks and tacked on to the rewritten mortgage. The trick would be organizing a massive “junk the settlement” campaign before this thing becomes official. Clearly, the banks are counting on that not happening.

  7. Vijay


    It’s rare that I disagree with anything you write, but this post is misguided. Taxpayers may be getting screwed, but not because of the expiration of the mortgage relief provision at issue. Let’s get a bit technical.

    Cancelled debt is includable in gross income under Section 61(a)(12) of the Tax Code (26 USC 61). If you’re an individual homeowner, this inclusion is turned off by Section 108(a)(1) of the Tax Code (26 uSC 108) if one of the following is true: 1) you’re in bankruptcy; 2) you’re insolvent; or 3) the cancelled debt is debt incurred to buy or improve your home and is discharged before January 1, 2013.

    The point of this post is that the third exemption, 108(a)(1)(E) expires at the end of the year and taxpayers who receive reductions at the end of the year are screwed.

    Some background to understand why the expiration of 108(a)(1)(E) is not that important. Section 108(a)(1)(E) was added as part of the Mortgage Forgiveness Debt Relief Act of 2007 largely in response to this NY Times article: http://www.nytimes.com/2007/08/20/business/20taxes.html?pagewanted=all

    As described in more detail by Bryan Camp (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1026002), the Congressional solution to the Stout’s problem assumed there was something inequitable about the income provisions of the tax code. Although when you actually examine the Stout’s case, it is apparent that the problem was not with the income provisions of the code but the reporting provisions.

    Prior to the relief act, the Stout’s cancelled debt would have most likely been excludable under the insolvency exception. This is true for most homeowners who are underwater and receive principal reductions. They are typically insolvent to the extent of the cancelled debt and the income is excludable. The relief act makes the reporting a bit easier for the taxpayer, but the additional exclusion in 108(a)(1)(E) is redundant for most homeowners.

    The real problem is the reporting requirements of the tax code. Changes to the code in the 1990s were made to require lenders to send the IRS 1099s when they forgave debt. This was presumably part of the crackdown on hapless debtors. Treasury Regs in 2004 (1.6050P-1) made these requirements more explicit. The problem with the reporting requirements is they place the burden on the homeowner to show that they fall within one of the exceptions, when the lender may be in a better position to make this call.

    This reporting problem was NEVER fixed. And the mortgage relief act offered little comfort for homeowners, who continued to receive large bills from the IRS after it was passed and had to deal with the issue in audit.

    Postponing the expiration 108(a)(1)(E) will really do nothing to solve this problem.

    1. Dave of Maryland

      Since corporations have so many advantages over private citizens, can’t we all just incorporate? Dave of Maryland, Inc. – ?

      1. citizendave

        …can’t we all just incorporate?

        Corporations recently gained personhood. Let people incorporate. Instead of same-gender marriage, it would be incorporation. For two adults living at the same address there would be no presumption by society of carnal knowledge. What goes on there is their business — and nobody else’s business. Sort of like the banks, unindicted regardless of what they do.

        1. Brooklin Bridge

          I’ll believe corporations are people as soon as Texas hangs one of them.

          (…Someone said that, Colbert?)

    2. Wendy

      Presumably, banks want to see documentation that a seller is in fact insolvent, in order to agree to the short sale. Is this correct? If it is, then couldn’t a seller simply submit a copy of that same information to the IRS to demonstrate insolvency, and thus applicability of the exception?

    3. Yves Smith Post author

      Thanks for your comment, but this is not as conclusive as you suggest.

      The mods are targeted to underwater, and not necessarily insolvent borrowers, so I don’t agree with your analysis of the fact set. They would be caught by the expiration.

      However, if Treasury decides not to pursue these borrowers, then this is moot under either analysis. That probably depends on who is elected. If it is the Republicans, you can be sure they’ll go after them in part to close the deficit and in part to undermine the settlement.

      And depending on what sort of automatic tax return screens are in place at the IRS, borrowers may get picked up even under Obama until some negative press gets it fixed. Your comments about reporting suggest that may be an issue, but since we haven’t had much in the way of principal mods (most mods so far have been payment reductions, and many have ADDED to principal balances by rolling late payments and various, often garbage, fees into them), we may not have enough happening to lead to the sort of media horror stories that would induce someone to fix a problem (as in the absence of reporting on this issue does not mean there is not a problem).

      1. Leviathan

        Just confirming your point, Yves. We did a Deed-in-lieu and were NOT insolvent. More than 200K was “forgiven” and, according to our lawyer, would have been taxable if not for the law that expires this year.

        Of course, if the point is to push as many families into BK as possible, then not renewing the act is a good idea.

      2. Knute Rife

        Yes, the problem has always been the difficulty of proving insolvency. Bankruptcy had been a safe harbor, but the great and glorious BAPCPA kicked a whole raft of people over to Chapter 13 (aka 3-5 years of indentured servitude). The new exception was to provide a new safe harbor. When it expires, the overwhelming bulk of debtors (and all solvent ones) will be stuck with bankruptcy (a nice gift to me as a bankruptcy attorney, but…).

        As an aside, many debt negotiation outfits are currently claiming that 20% of write-downs/write-offs result in tax obligations. That may be true relative to the numbers of debts (Most debts are small and not worth the paperwork. Additionally, many creditors are small and can’t or won’t deal with the paperwork.), it doesn’t apply to the overall amount of debt. If debt forgiveness is big (such as with a mortgage), I guarantee the 1099-C is coming.

      3. Vijay

        I agree it depends on the facts and it certainly possible that underwater homeowners who get reductions will not be insolvent and expiration of the relief provision will cause harm.

        The underlying point of my comment, though, remains. There is a reporting problem that needs to be fixed. Treasury has solved this issue with respect to bankruptcies (on the 1099-Cs, lenders indicate debt was forgiven in a bankruptcy), there could be something similar that allows the IRS to separate 1099-C where the cancelled debt is not likely taxable from ones where it is.

        It’s also worth mentioning that lenders are notoriously and unsurprisingly sloppy with 1099-Cs. Not sending them to the borrower, sending them to the service even when the debt is recourse and they are pursuing deficiency, listing the entire amount of the debt as opposed to the cancelled portion. Fixing these errors is a nightmare from the taxpayers perspective.

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