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It’s not exactly pleasant being a nay-sayer about a popular Occupy Wall Street initiative launched by a working group called Strike Debt, that of buying consumer debt at a discount and forgiving it, particularly when the movement generally is demonstrating its effectiveness and relevance. Recent accomplishments include Occupy Sandy proving more competent at disaster relief than either the Red Cross or FEMA, and Strike Debt publishing , the Debt Resistors’ Operations Manual.
If you stand far enough away, the Strike Debt debt cancellation initiative, called Rolling Jubilee, looks like a simple and clever way to beat banks at their own game. So it’s not surprising that it has attracted a roster of celebrity supporters. But like most things in finance, the devil lies in the details, and the Rolling Jubilee plan, on closer inspection, is wanting. It suffers from three flaws: it enriches the participants in a seedy backwater and may wind up leading banks to try to foist clearly unenforceable debt onto the new chump buyer, OWS. Second, the OWS effort is likely to be trivial relative to the scale of the problem, thus diverting energy and attention from broader scale remedies. Third, tax risks in the plan mean it could wind up doing far more harm than good.
The first two problems seem obvious, yet have been ignored by many. Debt collection is a shakedown operation. And I’m puzzled at the lack of instinctive revulsion to a plan that perpetuates and enriches the participants in abusive practices. I don’t think you’d see such enthusiasm, say, for a plan to deal with trafficking in women by raising funds to buy a few of the victims from the sex slave traders and free them. But the economic relationship to a predatory system is similar.
Most of the debt that winds up in the hands of debt collectors is unenforceable. Some of the time credit that was extinguished in bankruptcy, disputed by the borrower but somehow not erased from lender records, or past the statute of limitations. [check Chase]. Even when the borrower did incur the debt, it often is not enforceable if challenged. The lender needs to provide evidence both that the borrower incurred the obligation (such as the signed credit card agreement and any related amendments to substantiate interest rate charges; records of the specific charge and the payment history to show the amount is still outstanding). But many borrowers are afraid of debt collectors (who often engage in abusive and illegal strategies, like calling more than once a day and harassing borrowers at work) and ignore letters and court summons. In addition, some lenders also engage in “sewer service” as in never letting the borrower know they are scheduled for a hearing before a judge. As a result, even if the debt isn’t valid, if a debt collector goes to court and the borrower does not contest his filing, the collector will get a default judgment and can garnish wages or have the borrower’s bank account debited. That’s the reason this sort of debt trades for pennies on the dollar; the original lender probably would have secured payment if the borrower had the means of paying and the debt was legitimate.
The effect of Occupy Wall Street entering as a buyer if they operate on any scale (which remains to be seen) would be to increase the price of this junk debt. Given that banks like Chase have been found to knowingly sell clearly invalid debt to debt collectors, the presence of another bidder in the market is almost certain to raise the price of debt sent to collection. And it has the potential to increase gaming via banks selling more debt that they know is invalid but would take work for a third party to ascertain that (such as debt discharged in bankruptcy).
The second failing is that the scale of this effort is likely to be too small to have much impact. That reduces the risk of OWS’s operation leading to much in the way of price increases of junk debt, but it renders the activity more like handing $5 bills to homeless people: it provided random relief but doesn’t address root causes. Doug Henwood does some calculations:
So far, both Rolling Jubilee and the commentators have been rather light with numbers. As I’m writing this, RJ has raised $137,688. Since they figure they can buy bad debt for about five cents on the dollar, that means they could “abolish” (the evocation of the anti-slavery movement is no accident) $2,758,584 in debt. Though they don’t say, it’s almost certain that the debt they aim to buy is the credit card kind. Student debt, even if delinquent, isn’t sold into the secondary market. Debt backed by things—as auto loans are by vehicles and mortgages by houses—aren’t generally sold that way either, because lenders can seize the underlying assets. Though there are other kinds of unsecured personal loans (those backed by pledges only, and not things), the bulk of them are credit cards, so we’ll do the math on them.
According to the FDIC, there was $664.3 billion credit card debt outstanding in the second quarter of 2012. Of that, $16.5 billion was 30 days or more past due. Banks had charged off $8.5 billion. They’re required by regulators to do that once an account is 180 days past due, but that doesn’t mean the debt is extinguished. Though the bank removes the asset from its balance sheet and takes a (tax-deductible) loss, the debt still exists. The bank can try to collect it on its own, or sell the bad debt to the vultures described above.
Let’s think about that $8.5 billion. The people who owe that money are probably getting threatening communications from the banks or whoever now holds the claims. If RJ could raise $1 million—they’re more than 1/8th of the way there now—they could buy $20 million in debt, or 0.2% of what’s been charged off. To buy all the charged-off debt at five cents on the dollar, they’d need to raise $423 million. But of course if any more than notional amounts of money were put to this task, the price of the debt would rise dramatically. To buy a tenth of it at ten cents on the dollar they’d need $85 million. In other words, given those sums, the monetary angle for RJ is purely symbolic.
Strike Debt had a fundraiser on Friday and is up to be able to forgive $5 million, which they claim will be medical debt. But as you can see, this is a drop in the bucket.
The third issue, which the promoters of this idea are glossing over, is that this scheme has tax risks. Normally, forgiveness of debt is taxable income to the borrower and the party writing off the debt is required to notify the IRS. Strike Debt cheerily asserts in its FAQ that they can treat the forgiveness as a gift and escape this obligation. They also claim to have gotten “advice” but query the caliber of this advice; the people who come up with tax avoidance devices that are stricken down by the IRS are also professionals and gave advice that their program would pass muster.
The reading I have gotten from recognized tax experts is that this issue really is grey. The applicable law is binary: debt forgiveness = income in the amount of the debt, unless it’s a gift. And even if it is a gift, there could be gift tax payable by the donor. The usual limit for the gift tax exclusion is $13,000 per donee per year. OWS does not appear to have allowed for its exposure to gift taxes in its calculations of how much debt it can extinguish.
The problem here is the application of this law to Strike Debt facts. No one can be sure until a court issues a ruling. Whether something is a gift is a factual question. The IRS will not give a ruling on whether something is a gift. That’s why there can be no definitive answer.
Moreover, it’s problematic when the giver of the gift is the holder of the debt, standing in the shoes of the lender. That makes it look a lot like straight-up debt forgiveness. And the “abolish” language that Strike Debt has used in its literature is consistent with that characterization.
There was a temporary mortgage relief provision enacted in 2007 that expires in 2013. The existence of that exception reinforces the view that debt cancellation = income unless a specific exception applies (section 108(a)(1)(E)). Especially since many mortgages are held by investors who are not the original lender.
Here is what the IRS says about debt cancellation by gift (1995 Market Segment Specialization paper for grain farmers):
Cancellation by Gift (IRC section 102)
Gifts or bequests are excluded from gross income. Congress recognized that the presence of donative intent on the part of the creditor is difficult (if not impossible) to establish in a business setting. The committee reports accompanying the Bankruptcy Tax Act of 1980 state: “*** it is intended that there will not be any gift exception in a commercial context (such as, a shareholder-corporation relationship) to the general rule that income is realized on discharge of indebtedness.” Thus, the gift exception generally applies only in noncommercial contexts.
OWS is relying on the notion that they are organized as a not for profit and is not making money as a lender, hence this make their activity noncommericial. The sale of debt is a commercial activity. When OWS purchases debt, it enters into a commercial relationship with the debtor. OWS would have to overcome the IRS interpetation of legislative intent that there can be no gift in a commercial context. Case law requires detached and disinterested generosity on the part of the donor for a gift. Moreover, middle class borrowers are not considered a proper charitable class under the tax law.
Even if OWS can prove forgiveness is a gift, gift tax may be owed. The donor owes gift tax on a transfer unless it is $13,000 or less per donee per year. The medical expense exception to the taxable gift statute requires direct payment to the provider of medical services. Reimbursement of medical expenses is subject to gift tax.
Now you might say, but who would raise this issue? The IRS might decide to go after Strike Debt directly, either for failure to report debt cancellations or for gift taxes due. Or the issue might come up on an individual level (for instance, people who are going through ugly divorces can have their ex report them to the IRS out of a desire for vengeance and in the hope of collecting a whistleblower award if the IRS pursues their lead and prevails). OWS risks making a test case out of an effort to help a hapless middle class borrower.
I wish Strike Debt had gone about this in a way that would address the problem of abusive debt collection more broadly. For instance, in the mortgage space, counsellors and Legal Aid have been enormously helpful to stressed homeowners. The debt collectors often have weak enough cases that an adequately represented individual could defeat in court.
Strike Debt might also be able to use its debt purchases to develop legal theories for suing the debt sellers (as in they are engaging in fraud by selling debts that are invalid) or suing debt collectors for harassment. Strike Debt also might want to work to get debtor/creditor laws changed. The problem is that really making a dent on this issue is a hard slog, and doesn’t lend itself to the appearance of quick and easy victories that make for good solicitation pitches.
I hope the tax issue does not blow up on Strike Debt and the people it is trying to help. The Rolling Jubilee program has helped raise the profile of the issue of abusive debt collection and helps demonstrate that OWS is not a flash in the pan. But, sadly, beating banks at their own game is unlikely to be an easy proposition.