As everyone has noticed by now, the country is in a housing slump--it's harder to sell a house, new or old. Houses are staying on the market longer, increasing the costs to sellers (mortgage costs continue to require monthly payment, taxes, and utilities). Some would-be sellers end up unable to keep up the payments, resulting in loss of their homes to foreclosure. The mounting foreclosures then affect prices, resulting in more owners selling for less than they had hoped and sometimes for less than the mortgage on the house. And the owners who lose their homes may face tax consequences because of cancellation of debt (COD) income. See this discussion of COD income at taxalmanac.org.
A number of people who have limited means may be affected by this. There are, in fact, a number of provisions in the law that can help. For example, COD income may not be taxable if the homeowner comes within a provision of the laws providing for exclusion of COD income because of the homeowner's bankruptcy or insolvency. Or if the homeowner has gain on the foreclosure related to a nonrecourse mortgage loan, that homeowner may be eligible for an exclusion for that gain based on qualified ownership and residence.
Some websites carry information about the treatment of COD income, but described in language that appears to instill misunderstandings. One such example is Dan Green's Daily Mortgage Report which discusses COD income at this link. Note that blogger Green talks about "a nasty piece of IRS tax code" and suggests that it is an arbitrary decision by the IRS to treat the COD income as taxable income.
Another example is another libertarian blog (which seems to be an advocacy blog for congressman Ron Paul's version of libertarianism). From Reason to Freedom talks about an "unfair IRS tax policy" --as though treating the release from an obligation to repay money borrowed (and therefore the ability to have used the borrowed money without having to pay it back) as taxable income is an invention of the tax administrator rather than a fair and reasonable part of the laws as administered by Congress. This blog ends with a line which shows its ideological bent--anti-tax and anti-government.
Strict reins must be put on the IRS by Congress to limit as much as possible the damage it does to the taxpayer and to the American dream. Id.
These blogs should be debunked. The treatment of COD income as taxable is Congress's rule and it is a reasonable one. The IRS doesn't damage the taxpayer or the American dream by enforcing the basic tax laws in a reasonable way. The IRS is not the enemy here, even though liberatarians these days try to paint it as such. See, e.g., Machon (Chapman business professor, Hoover Institution), The Feudalist and Socialist Nature of Taxation and Machon, No Taxation With or Without Representation: Completing the Revolutionary Break with Feudalist Practices (claiming that taxes are inherently bad and a vestige of monarchism and feudalism and that "sovereign individuals" should not fund governments through taxation but through a voluntary system). As someone on the tax prof listserve noted today, the IRS is not the enacter of the tax code: It is Congress, elected by the people, that passes tax laws, which are codified in the Internal Revenue Code. The IRS is merely the tax administrator that attempts to implement the laws. The treatment of COD income has been around for quite a while, and most tax experts consider quite reasonable the Code's treatment of COD income as taxable income, unless one of the exceptions like bankruptcy or insolvency applies to exclude the COD income from consideration. The borrower had the benefit of the loan and the property purchased with the loaned proceeds without paying tax on the debt amount, on the assumption that the borrower would pay off the principal. When that assumption proves wrong, then the borrower has gotten an economic benefit and should be taxed currently for that past benefit received. The IRS is being a reasonable enforcer of the laws in treating forgiven debt as income.
But several people have suggested that the government needs to take action--either to help lenders who stand to lose a considerable amount because of their eagerness to extend credit to people with not-so-good creditworthiness (so-called "subprime loans") or to help borrowers who got in over their heads. There are a number of the latter. Some people bought properties to "flip", thinking that there was no trajectory but up. Other people bought homes, and face the loss of that home due to foreclosures.
Does the government need to protect lenders who let themselves get carried away with the profits possibly to be made by high interest rates on subprime loans and forget the real risks of losses due to default? Seems like that would be a mistake. After all, businesses take risks all the time, and many of them fail because of the risks they have taken.
Does the government need to protect borrowers? Surely most borrowers should not be protected--where it's a business or investment (flipping), then borrowers should bear the risk they entered into. Where a borrower has considerable assets (and hence is not eligible for the bankruptcy or insolvency exceptions or anywhere near eligible), surely the government shouldn't step in to reduce the tax liability otherwise owed and force other taxpayers to share in that borrower's loss. And even for most people with very few assets, the government doesn't need to create new protections, since there are already bankruptcy and insolvency exceptions to taxation. There may, at the margins, be some real concern for people who are just at the border of insolvency but not eligible for the exception or for people who were victims of aggressive lenders who pushed them to take out more credit than they otherwise would have. At most, Congress might act to extend the application of the exclusion to some portion of the COD income for those foreclosed borrowers just at the brink of insolvency.
The Bush administration has proposed that the government intervene, at least for some borrowers, by making refinancing of adjustable rate mortgages (ARMs) easier to obtain. See this White House Release and this commentary on Debthelp.com. The Federal Housing authority would make it easier for homeowners with ARMs by providing insurance that facilitates refinancing the ARMs.
The Bush administration has also said it would support a provision now before Congress to forgive COD income that arises in connection with home mortgages. See this White House release. The bill being considered is HR 1876 and its Senate companion, S 1394. See H.R. 1876, the Mortgage Cancellation Relief Act of 2007, with text of the bill at this link. Various groups with a good bit of self-interest at stake are supporting passage of the bill. See this argument by NAR, which paints a misleading picture of the problem while glossing over the existing exceptions to recognition of COD income and the potential application of the section 121 gain exclusion rule for home sales. And this lobbying effort by Tennessee Realtors.
The act is frequently discussed as needed from a fairness perspective. See, e.g., Tax Relief Bill Could Ease Homeowners' Struggles, Herald Tribune. But readers beware: why is it that home mortgage debt relief should be tax free when the home owner, after all, had the benefit of the home purchased with that debt and now has no obligation to repay the debt? What about others who used debt proceeds to buy other assets and who will be appropriately taxed on their debt relief. Our basic notion of fairness rebels against provision of special relief to one group (homeowners) that other groups don't have.
In fact, homeowners already are subsidized extensively under the Code through the mortgage interest deduction, which operates as an upside down subsidy--rich people get much more of the benefit than poor people do. We don't need to add yet another subsidy that will be most beneficial to people at the top of the income distribution, especially when the bankruptcy and insolvency exceptions take care of the people we most care about not being hurt by the foreclosure/COD problem. Similar ideas are expressed in a Kamen blog entry opposing the bailout provision, at this link, along with some interesting comments by readers.
Whatever minimal relief might make sense (and it should be minimal and only directed towards those at the bottom of the income distribution), it is clear that helpful and accurate information about the impact of foreclosures on potential taxes is important. Today, the IRS issued a news release related to the issue of relief from liabilities upon foreclosure that addresses this need. See IR-2007-159. In the release, the IRS announced information on its website about possible tax consequences of foreclosures. The IRS provides a Q/A which explains some of the different consequences of recourse and nonrecourse debt and the various possible exceptions that may apply to make cancellation of debt income not taxable (e.g., bankruptcy, insolvency). This increase in transparency about the tax laws that apply to foreclosures and debt relief is helpful.
Note (added 9/18/09): Deborah Geier has an article addressing the different treatment of recourse and nonrecourse debt. See Deborah A. Geier, Tufts and the Evolution of Debt-Discharge Theory, 1 Florida Tax Review 115 (1992).