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SUBPRIME MORTGAGES, SAD STORIES AND THE IRS

May 07, 2007

The Washington Post has published "IRS Kicks Homeowners While They Are Down." Needless to say, the piece has a point of view.

The subprime mortgage market has been hit by an entirely predictable wave a delinquencies. Some of these are being worked out by having some of the debt cancelled. As the article points out, this debt cancellation can be taxable:

For homeowners who are seriously delinquent on their mortgages and hoping for relief, the IRS has bad news: If your lender agrees to modify your loan and forgive any of your debt, you could owe federal income tax on the amount forgiven. Think of it as the tax code's "kick 'em while they're down" rule. When personal debts are canceled by a creditor, the amount forgiven is treated as ordinary income under the Internal Revenue Code, except in some situations such as insolvency. Worse yet, the lender is required by law to report the canceled amount to the IRS.

"Worse yet"? You mean you might get caught if you cheat on your taxes? How unfair.

Similar situations are likely to pop up around the country in the coming year as lenders bend over backward to modify thousands of troubled loans to prevent foreclosure. Proposed legislation on Capitol Hill could soften some of the impact on financially stressed homeowners, however. The Mortgage Cancellation Tax Relief Act of 2007 (H.R. 1876) would amend the tax code to exclude debt forgiveness on principal home mortgages from treatment as income.

Tax policy by sad story. A lot of these people borrowed money to buy houses they couldn't afford otherwise. Now that they aren't making the payments, lenders are letting them keep the house while writing down the loan. The bank is giving these folks thousands of dollars of home equity.

The tax law already lets borrowers exclude debt forgiveness from income to the extent the borrower is insolvent (that is, to the extent their debts exceed the value of their assets). The Washington Post article mentions this in passing. Does it really make sense to let solvent debtors get tax-free home equity?

HR 1876 would create a new privileged class of income, followed inevitably by unintended consequences. Big companies would probably set up mortgage subsidiaries to make home loans to their executives, which would then be forgiven tax free. Making mortgage debt tax free would also encourage people to borrow too much for home debt -- something the tax laws do too much already. But sad stories from borrowers who have overextended themselves will probably carry the day.

Hat tip: TaxProf Blog.

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