Yesterday, I wrote a bit about the housing slump and the tax consequences that may surprise taxpayers who lose mortgaged houses in foreclosure proceedings (or in-lieu-of process). See this post. In a nutshell, my key points were:
- insolvency and bankruptcy exceptions on recognition of cancellation of debt (COD) income when debt on residences is forgiven may well apply to many individuals whose creditors forgive part of the debt (either because the creditor accepts the proceeds of a "short sale" for less than the amount of the debt without redress against the seller for the full amount or because a foreclosure auction or in-lieu-of-foreclosure procedure results in an amount less than the full value of the mortgage and the creditor cannot or agrees not to seek further redress from the seller), while section 121 (which excludes gain on a home sale if certain residence and ownership requirements are met) may apply to exclude gain from a foreclosure sale;
- the IRS has issued a Q/A to respond to the concern that many taxpayers will have to face this issue for the first time and be uncertain about tax consequences
- the Bush administration and various members of Congress are calling for more relief through amendments to the Code (which relief is hard to justify, except just maybe if it is shaped as relief for those who are very very close to bankruptcy or insolvency); and
- various groups are pushing for Congressional action--realtors, as a way to bolster their industry and others that appear to be from the libertarian anti-tax and anti-government fringe--with commentary that often appears biased by casting the IRS as a devil that created the taxation of COD income out of whole cloth.
I left out one item of interest that I should have mentioned--a letter from Senators Grassley, Smith and Roberts to the IRS urging action by the IRS to solve the problem and asking the IRS to let Congress know if it thinks Congress should do something. This is a strange letter, to say the least. Congressional action is both (i) the appropriate means of enacting a subsidy for a particular group of taxpayers, if subsidy there must be, and (ii) likely to be much more impactful at an earlier point than the offers in compromise that will take some time to wend their way into the tax administration system.
What is most interesting about the Grassley letter, however, is not Grassley's apparent tossing of the ball out of Congress's court. It is the attachment (at least on Grassley's website presentation of the text of the letter) of a New York Times article by Geraldine Fabrikant, After foreclosure, a Big Tax Bill from the IRS (Aug. 20, 2007), that was likely intended to illustrate the housing slump with human interest stories that garner our sympathy, but which mimics the tone of the libertarian fringe group discussion of the issue. The article discusses taxation of COD income as "an Internal Revenue Service policy that treats forgiven debt of all types as income even if the taxpayer has nothing tangible to show for it, unless the debt is canceled through bankruptcy". It quotes a professor at Chapman who makes a similar statement that "the IRS says you owe tens of thousands of dollars in taxes because you got a windfall when the debt was forgiven." Yet this rule is clearly part of the tax laws enacted by Congress: section 61 of the Internal Revenue Code includes COD amounts in income, while section 108 provides various exceptions, including for bankruptcy and insolvency. Both of these statements could mislead Americans into thinking that the tax they pay on the economic benefit they received from a loan that is later forgiven is just another example of a perverse agency that, willy-nilly, takes away their money based on crazy views of what is taxable. That article merits criticism for casting the IRS as the devil and for failing to point out the fundamental tax norm operating in this context--that people who have debt forgiven have received a substantial economic benefit that should be taxed, unless the taxpayer is in economic straits and unable to make payment, in which case the Code provides appropriate help through the insolvency and bankruptcy exceptions.
Take the article's disussion of the case of Agnes Mouser, a sixty-five-year-old who paid high points to Beneficial to get a high interest home equity loan in an improbably high amount on her old trailer to pay off her credit card debt, after Beneficial's appraiser gave the trailer an improbably high value. Later, when she (predictably) had trouble paying off the loan, she got the lender to release the lien but found she owed tax on the amount forgiven. Note that Ms. Mouser received a loan to pay off credit card debt. That was a real economic benefit that, if not repaid, is clearly income. Yet the quote from her lawyer implies that the IRS was inappropriately seeking taxes on that income, perhaps even harassing her. “It took a letter from an accountant and two letters from me to get the I.R.S. to go away.”
What one can't help thinking in reading the Times article is that the real culprit in Ms. Mouser's case is Beneficial, an apparently rapacious lender that wanted those very high interest rates and so sold her on a loan that she really couldn't afford. Congress would do better to leave the insolvency exception to do its work to protect homeowners from COD income in appropriate cases and instead cast a critical eye on the practices of lenders, from charging exorbitant "points" up front, to piling on one fee after another, and for using high pressure tactics with vulnerable people to get them to agree to too much at too high a rate in the first place.
(And while they are considering that, they should look into the practice of lenders and affiliates who send out official looking "notices" "response required" to new borrowers to get them to sign up for additional costly services, like "mortgage protection" after they have the loan. I've received at least a dozen of those letters, which I've collected to send along to my representative with a letter about this issue, since I bought my home in Detroit in late May of this year. I suspect that the people who can least afford it are the ones who are the most vulnerable to this pressure.)
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