The
letter from Bank of America Home Loans got right to the point. “We are
pleased to inform you that we have approved your Home Equity Account for
participation in a principal forgiveness program offered as a result of
the Department of Justice and State Attorneys General global settlement
with major mortgage servicers.” In the letter, which I obtained from an
anti-foreclosure activist, Bank of America offered the homeowner full
forgiveness of their entire home equity loan balance of over $177,000.
But then Paragraph 5 came with an ominous warning: “Please be aware that
we are required to report the amount of your cancelled principal debt
to the Internal Revenue Service.”
Under current law, a principal
reduction like this would be exempted from tax liability. However, that
law, the Mortgage Forgiveness Debt Relief Act, expires at the end of the
year, and after that, any mortgage debt forgiveness provided to a
borrower will count as gross income for tax purposes, potentially
costing millions of families several billion dollars. In the above case,
the borrower would be required to pay taxes on the entire $177,000
amount forgiven by the bank, as if it were earned income. And that’s
money that struggling homeowners simply don’t have.
“They wouldn’t
be able to handle it,” said Peggy Mears of the Alliance of Californians
for Community Empowerment, a community organizing group in California
that has worked extensively on foreclosure issues. “If they could handle
it, they wouldn’t be in arrears with their house notes. They don’t have
that kind of money.”
The tax issue could significantly disrupt a
still-fragile housing market and rob homeowners of the tools to pull
themselves out of mortgage debt. It also represents a final indignity
for homeowners who have been abused by the fraudulent mortgage practices
of leading banks for years. Just when they think they get relief from
their troubles, they get hit with a massive tax bill they cannot pay.
“This has the effect of pulling people up with one hand, and hitting
them in the face and knocking them over the cliff with the other,” said
Sen. Jeff Merkley, D-Ore., who supports extending the law.
The
issue dates back to 2007, when the housing bubble first started to
deflate. Rep. Brad Miller, D-N.C., was tasked by the then-chairman of
the House Financial Services Committee, Barney Frank , D-Mass., to find
ways to help borrowers who would get caught up in the ensuing carnage.
Miller’s search led him to Section 181 of the tax code. “I heard about
the fact that interest reductions are not treated as income and
principal reductions are, which creates a huge problem for modifying
mortgages and solving the foreclosure crisis,” Miller said.
The
odds of foreclosure largely correlate with a borrower’s level of
indebtedness. A homeowner who’s “underwater,” meaning he or she owes
more on the home than it’s worth, is far more likely to miss payments
that a borrower with equity. And studies show that principal reductions
do a far better job than
any other kind of loan modification in helping borrowers maintain
payments and avoid foreclosure. If you privilege other modifications
through the tax code, like reducing the interest rate, over principal
reductions, you punish those homeowners receiving the most sustainable
type of modification, and eventually take them off the table, leading to
a weaker housing recovery.
“I suggested to Barney [Frank] that we
create an exemption for principal reductions,” Miller said. “Barney
said to me, ‘Let’s go talk to Richie,’” meaning Richard Neal, the
chairman of the tax-writing subcommittee in the House. Neal agreed to
help, and the change got added as an amendment to an unrelated bill.
That
first exemption lasted three years, but the foreclosure crisis lingered
on beyond that. Democrats were able to include an extension in the
larger deal that extended all of the Bush tax cuts for two years. Now
the law is scheduled to expire again on Dec. 31, 2012. Any debt relief
that completes after that date would be taxable.
The difference
now is that principal reductions and other debt relief are set to become
more widespread. Banks have been extremely resistant over the last
several years to grant principal reductions, which forces them to take
an up-front loss. Even if, over time, the greater probability of the
borrower maintaining the payments makes it more cost-efficient for the
bank than the risk of a bigger loss in foreclosure, banks do not want to
mark the immediate loss on their books. In addition, mortgage
servicers, who manage securitized loans sold to investors, get
compensated through a percentage of unpaid principal balance, so
principal forgiveness represents a direct cut into their profits.
Because
of the mortgage settlement, banks are mandated to forgive at least $10
billion of principal, as a punishment for using false documentation to
foreclose on homeowners, among other abuses. Though this is a relatively
small amount of forgiveness (homeowners have roughly $700 billion in
negative equity on their mortgages), the implications for the borrowers
who receive it are significant. A $100,000 principal reduction for a
family making the median adjusted gross income of $32,393 would
calculate to an additional tax bill of roughly $21,200. And most
homeowners threatened with foreclosure and in need of a principal
reduction have far poorer finances than the median. “’I’m on
unemployment and I just got a $20,000 tax bill?’” said Ira Rheingold of
the National Association of Consumer Advocates. “This would be so
counter to public policy, it makes absolutely no sense.”
In
addition, the tax exemption also covers short sales, which have
increasingly become an option for banks and homeowners to avoid
foreclosure. In a short sale, the bank agrees to allow homeowners to
sell their property for less than the value of their mortgage, forgiving
the balance. The borrower walks away from the home without an eviction,
the property sells at a higher price in a short sale than a foreclosure
sale, and the bank doesn’t have the expense of maintenance and upkeep
on the property between eviction and the foreclosure sale. Short sales
increased 25 percent year-over-year in
the first quarter of 2012. But if the exemption expires, the homeowner
would have to pay tax on the balance forgiven by the bank in a short
sale, making this option much less attractive.
The mortgage
settlement added several other cases where homeowners would have to pay
taxes on awards from banks. Under the settlement, up to 750,000
foreclosure victims, who have already lost their homes, will receive
checks of $2,000 as compensation for foreclosure fraud. But the
settlement language did not make clear that the cash reward represented
compensatory damages, and as a result, these checks could be taxed.
Similarly, service members stand to get compensation of $116,800 or
more, due to a series of violations under the Servicemembers Civil
Relief Act, including incidents where banks illegally foreclosed on
military members while they were deployed overseas. But because of the
vagueness of the language, they could be taxed as well. Rep. Brad Miller
said he advised those involved in writing the settlement that they
should try to make everything, including the mandated principal
reductions, explicitly portrayed as compensatory damages, to ensure the
exclusion from tax liability. “They had no idea what I was talking
about,” Miller said.
At this point, only Congress can fix this
problem by extending the exemption, and there are two parallel efforts
underway to do so. Sen. Debbie Stabenow, D-Mich., has
sponsored a bill,
S.2250, which would prevent taxation on all debt forgiveness, like
principal reduction or short sales, through the end of 2013. That bill
has 17 co-sponsors, including four Republicans (Dean Heller, Scott
Brown, Susan Collins and Johnny Isakson), as well as the support of the
White House, which called for it in its proposed budget. Rep. Jim
McDermott, D-Wash., has a more extensive bill in the House,
H.R.4290,
which would not only relieve the tax burden for principal forgiveness,
but also exempt the direct cash payments to homeowners from the mortgage
settlement. It would also stop banks from taking a deduction for any
payments they make for Servicemembers Civil Relief Act violations. That
bill has 42 co-sponsors, but no Republicans. “I wanted to put an idea
out there and let it cook,” McDermott said. “I can’t ram it through, I
can’t get a hearing on it in the Ways and Means Committee. But people
can look at it, decide it’s a good idea, take it and shape it.”
Given
that this is in essence a tax cut – the Congressional Budget Office
estimates that excluding principal reductions from taxation for two more
years will save recipients $2.7 billion — many Democrats in Washington
believe that Republicans will eventually get onboard. But that’s no
guarantee. “I’m not sure we can get that extended,” Rep. Miller said.
“Republicans are not keen on principal reduction in the first place.
When we extended the law in 2010, that was considered a give to
Democrats.” Given that the tax issue would in all likelihood bring
principal reductions to a screeching halt, Republicans could view
resisting an extension as a way to stop something where they have
ideological opposition. And it could be used as a bargaining chip in
other negotiations.
In addition, it’s not like Congress has
nothing to work on in the lame duck session, where this will probably
get decided. Lawmakers must navigate a host of issues, including
trillions of dollars in fiscal measures like the Bush tax cuts, the
automatic sequester of $1.2 trillion in discretionary and defense
spending, the alternative minimum tax and much more. With all this
packed into a short space of legislating, the principal reduction issue
could easily get lost in the shuffle. And it’s not as if Washington has
made a priority out of granting relief to homeowners over the past
several years. “In a rational world with a rational Congress, I would
not be concerned,” Rheingold, of NACA, said. “But we don’t have that.”
At
stake is the future of the housing market itself. Though analysts keep
touting a bottoming out of prices and home sales, the numbers suggest
that there’s still a long way to go, and the biggest stumbling block
remains negative equity. “For us to get to a housing recovery, we really
do need significant principal reduction,” said Rheingold. “As we’re
seeing the first signs of doing any principal reduction or short sales,
if this tax relief is allowed to expire, it would really do tremendous
damage.”
But consumer and housing advocates have not engaged on
the issue yet, though they have relentlessly demanded more principal
reductions. “It’s not something that a lot of us have been thinking or
talking about,” acknowledged Rheingold. “We’re thinking about
implementation of the settlement, and whether there will be principal
reductions, not these other hazards.” Housing advocates have called on
Ed DeMarco, the head of the Federal Housing Finance Agency, to authorize
principal reductions on loans owned by Fannie Mae and Freddie Mac. And
his
rejection of this has
spurred calls for President Obama to fire him. But this issue, which
would punish the beneficiaries of those principal reductions with a
giant tax bill, has not generated the same level of outrage.
There’s
still time for a fix. An extension would probably get folded into some
other must-pass bill at the end of the legislative session, reasoned
Sen. Merkley. There’s also the possibility of dealing with it
retroactively sometime in 2013, before homeowners get the big surprise
on their 2013 taxes. “I’ve heard no one defend the way the law will go,”
Merkley said. Rep. McDermott, the lead sponsor in the House, saw
options as well. “The legislative process can move very rapidly when it
wants to,” he said. “When there’s a will, there’s always a way. What’s
troublesome is finding out if anybody cares.”
Peggy Mears, of
ACCE, said that her organization would begin to talk to its members
about the issue. “We’re going to refuse to give up fighting for
homeowners,” she said. “It would be a shame for people in Congress to
pull money out of the consumer’s pockets.”
Without a strong push
from outside advocates and attention from lawmakers, an extension will
be a challenge. And homeowners abused by banks throughout the mortgage
process would suffer a final nightmare courtesy of the Internal Revenue
Service. “Of all the tax changes likely to expire,” Rep. Brad Miller
said, “this is the one that causes me the most concern.”
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