Official Argues Against Short-Sale/Foreclosure Deficiency Counting as Income in 2014

In a speech given recently to a housing industry group Michael Stegman assistant Treasury Secretary for Housing Finance Policy made a plea for renewal of the Mortgage Forgiveness Debt Relief Act, which expired at the end of the 2013.  The act, first passed in 2007 and extended in 2009 and 2011, is what is commonly called a "tax extender."  Under the legislation a homeowner for whom some portion of his mortgage balance is forgiven through a loan modification or following a short sale, a deed-in-lieu, or a completed foreclosure does not have to treat that forgiven debt as income for purposes of federal taxes.

Stegman said, "Failing to extend this provision could force struggling families to settle for a less effective mortgage modification, or choose foreclosure over better alternatives for families and their community Congress should do the right thing and extend this targeted tax forgiveness now."

With the law no longer in effect, here is a rough example of what could happen.  A homeowner who has lost his job is no longer able to maintain payments on his mortgage on a home he purchased in 2004 for $200,000.  His original mortgage has been paid down to $150,000 but $8,000 in unpaid interest, late fees, penalties, and legal fees has accrued. The house, in an extremely distressed part of California, is now valued at $130,000.   The homeowner is able to find a buyer for the home at the current market value and the proceeds after real estate commissions, back taxes, and other costs results in a payment to the bank of $122,000.   At the conclusion of the short sale transaction the lender writes off the remaining balance of $36,000 and gives the seller a 1099 showing that amount as unearned income for the year.  On April 15 of the following year the IRS will expect the homeowner, even if he had no other income for the year, to pony up over $1,000 in taxes on that forgiven debt.

Two bills authorizing extension of the law were introduced last summer.  HR 2788, sponsored by Joe Heck (R-NV) is currently sitting in the House Ways and Means Committee and S1187 sponsored by Debbie Stabenow has been referred to the Senate Finance Committee.  In his appeal for passage of the extensions Stegman notes, "Congress often passes tax extenders late in the year and makes them retroactive to the beginning of the tax year. While this is generally well understood and incorporated into firms' decision-making, it does not work for families in danger of losing their homes today."

Critics of the bill note that the debt forgiveness costs the government a lot of tax money and that the worst of the crisis has passed so homeowners no longer need relief.  Supporters claim that the crisis is far from over.  While the level of distress has certainly abated from its peak, RealtyTrac says that 1.2 homes are still in the process of foreclosure.  Many of those homeowners will find the ultimate resolution of their situation will result in a mortgage deficiency balance.   Perhaps more of a reason for extending the law are the estimated 6.4 million homeowners nationwide (13 percent of all mortgaged homes) who CoreLogic says remain underwater on their mortgages and another 1.5 million who have less than 5 percent equity in their homes.  Any one of these people could have an event triggering a default on their mortgage or forcing them to sell their home at a loss and thus face a tax liability.

Beyond the economic hardship, Stegman alludes to another potential result of failing to extend the law.  If a tax liability looms at the end of the road, a homeowner may lose some enthusiasm for working through the process of a loan modification.  There is even less reason for giving a deed-in-lieu or completing a short sale because at the end of those sometimes difficult negotiations the homeowner might have a tax bill but no longer has his home.   Either of these outcomes could result in a higher rate of default as homeowners decide they have little to lose by simply walking away.

Edward J. DeMarco, an opponent of allowing Fannie Mae and Freddie Mac to use principal reduction as a loan modification tool, was recently replaced as head of the Federal Housing Finance Agency by Mel Watt who favors it.   In addition, some recent legal actions such as JP Morgan's $13 billion settlement with the Justice Department contain provisions requiring principal reductions.  Therefore, while it is possible we will see an increase in the use of principal reduction it is conceivable that any impact on default and foreclosure rates it may have will be muted by the potential of homeowners being taxed on the result.    

Heck, in a video prepared for his constituents (Nevada has an estimated 32.5 percent negative equity rate) calls forgiven debt "shadow income" and says of his reason for sponsoring the extension, "This isn't income.  The homeowner never sees a dime of that money.  The government should not tax income never actually received."