When homeowners are at risk of losing their home to foreclosure, the last thing they need is an extra tax bill. Congress passed the 2007 Mortgage Forgiveness Debt Relief Act ("the 2007 Act") specifically to avoid imposing extra taxes on distressed families, but as currently written, the law doesn't work.
In passing the 2007 Act, Congress recognized that taxing this debt relief would directly undermine the fundamental intent of mortgage write-downs, and the legislation exempts some debt relief from taxes. But there are two problems:
- The 2007 Act effectively denies this exemption to a large number of homeowners who at some point refinanced their mortgage for more than the amount of the original purchase price—loans that were aggressively marketed by lenders, encouraged by policy makers, and which seemed sensible when housing prices were rising.
- Even families who qualify for the tax relief often don't receive it because the paperwork required is so cumbersome. The National Taxpayer Advocate estimates that less than one percent of families eligible for the relief obtain it.1
Background on Mortgage Debt Cancellation
The IRS's National Taxpayer Advocate has flagged solving the tax problem surrounding mortgage debt cancellation, also called "principal reductions" or "write-downs," as a top priority. That's because the need for loan forgiveness is growing. One out of every four homeowners has a house whose mortgage is "underwater," meaning that its value is less—often substantially less—than the mortgage amount.
In this environment, there are many circumstances in which homeowners receive some debt relief related to their mortgage.
- Investors and policymakers are increasingly concluding that, for homeowners trying to remain in their homes, reducing the principal amount of mortgages is the most effective way to prevent foreclosures and restore sustainable homeownership.2
- Homeowners trying to sell their homes are obtaining permission for a "short sale," in which the lender agrees to accept less than the mortgage amount to fully satisfy the debt.
- For those who have already lost their homes through foreclosure, lenders sometimes agree to give up the right to collect on any balance that remains unpaid after a foreclosure sale.
The Treasury Department recently rolled out a program to encourage short sales as part of its Home Affordable program. At the same time, the White House, members of Congress and various industry participants are working to make principal reductions a larger part of any loan modification or refinancing program. However, unless this tax problem is fixed, these programs will be in jeopardy.
Why the 2007 Mortgage Debt Relief Law Doesn't Work
When a lender cancels or forgives any portion of a mortgage debt, the IRS treats that amount as taxable income to the homeowner unless the homeowner qualifies for a tax code exclusion such as the one created by the 2007 law. But the 2007 law defines the mortgage debt eligible for the exclusion as only that debt that was used to purchase the home or make major improvements to it. The definition of "major improvements" excludes many legitimate housing expenses. For example, the cost of replacing a roof is considered a repair rather than an improvement and is therefore ineligible for the exclusion.
A large majority of homeowners in trouble have at least some mortgage debt beyond that used to directly buy their home. More than half of all subprime mortgages were refinances rather than debt on a first-time home, and brokers and lenders encouraged these homeowners to take out a larger loan and use the extra money to make home repairs or to consolidate other debt. As the law now stands, many families will find that most, if not all, of their cancelled mortgage debt will be subject to income tax. That undermines the purpose of the 2007 law and means the homeowner must pay tax on a write-down meant to provide debt relief. In many cases, the tax consequence will make the difference between a successful and unsuccessful loan modification.
Even those homeowners whose mortgage debt qualifies for the exclusion find it extremely hard to claim. To do so, a homeowner now must file a long-form 1040 along with IRS Form 982, which the IRS estimates take many hours to complete. Most lower- and middle-income taxpayers are not accustomed to using these forms, and taxpayers filing long-form 1040s are not eligible to use the various tax clinics offered by the IRS and others.
The Solution: An Easy Legislative Fix
A simple three-word expansion of the law's mortgage definition ("Qualified Principal Residence Indebtedness") to include both acquisition AND home equity debt would result in fairer treatment of homeowners and former homeowners, and, in turn, result in effective foreclosure prevention. It also would potentially make it easier for taxpayers to claim the exclusion because it would free up the IRS to reduce the necessary paperwork.
These changes are needed to ensure that efforts by lenders and policymakers to assist struggling homeowners and stabilize the housing market are not unwittingly and unnecessarily undermined.
National Taxpayer Advocate's 2008 Annual Report to Congress, p. 394, available at http://www.irs.gov/advocate/article/0,,id=202276,00.html (the Office of the Taxpayer Advocate is an office within the Internal Revenue Service providing assistance to individual taxpayers and recommending to Congress administrative and legislative changes to the tax code).
First American Core Logic Negative Equity Report Q32009, available at http://www.facorelogic.com/newsroom/marketstudies/negative-equity-report.jsp See also Laurie Goodman, Roger Ashworth, Brian Landy, Ke Yin, Negative Equity Trumps Unemployment in Predicting Defaults, Amherst Mortgage Insight, Amherst Securities Group (Nov. 23, 2009); Shawn Tully, Lewie Ranieri Wants to Fix the Mortgage Mess, Fortune Magazine (Dec. 9, 2009); Andrew Haughwout, Ebiere Okah, and Joseph Tracy, Second Chances: Subprime Mortgage Modification and Re-Default, Federal Reserve Bank of New York Staff Report (December 2009).