In light of the recent House passage of H.R. 3648, providing for an exclusion for forgiven debt income on qualified residence debt cancellation, the Congressional Research Service has issued a report on various issues related to mortgage debt income exclusion. Download crs. Analysis of the Proposed Tax Exclusion for Canceled Mortgage Debt Income.Oct16.pdf
Noting that the rationale discussed has been the concern for homeowners who are are in stress when property values decline below the debt owed on the property, leading to lenders writing down the debt or to foreclosures with sales that are not sufficient to satisfy the debt, the report points out that there are already provisions in the tax laws that exclude debt cancellation income for insolvent or bankrupt taxpayers. Clearly, it is important that taxpayers in these circumstances be informed of the insolvency and bankruptcy exceptions, so that they are not taxed on the debt forgiveness income.
But for other taxpayers, it is not clear that debt cancellation income exclusion is necessary. The CRS report notes a number of equity issues that arise with the exclusion for taxpayers who are not insolvent.
"An exclusion of forgiven debt may also reduce the tax system’s progressivity — the proposed provision, in other words, would likely favor upper-income individuals. This would occur because an exclusion of a given amount is more valuable to persons with higher marginal tax rates. This effect would be magnified if homeownership is more concentrated among upper income individuals. … [Assuming debt cancellation income of $20,000, t]he value of the exclusion for a homeowner with lower income, who may be in the 15% income tax bracket, is $3,000, while the value to another homeowner, with higher income in the 28% bracket, is $5,600. Thus, the higher income taxpayer, with presumably greater ability to pay taxes, receives a greater tax benefit than the lower income taxpayer."
Similarly, the CRS notes the many subsidies for home ownership already provided in the tax laws. "The deduction for mortgage interest is the most costly provision, with an estimate of $85.2 billion in revenue loss for FY 2008. The exclusion of gain on the sales of homes is the second largest tax provision for homeowners, with an estimate of $30.1 billion in tax revenue loss for FY2008. The deduction of state and local real estate taxes is the third provision, with an estimate of $14.2 billion in tax revenue loss for FY2008."
Those subsidies benefit most taxpayers at the top of the income distribution where home ownership is concentrated and where tax brackets provide a greater benefit. They amount to significant incentives for substantial investment in housing. Those incentives have led some economists to suggest that the tax laws cause Americans to over invest in housing, to the detriment of more productive investments that would strengthen the economy.
If Congress decides to enact a debt cancellation exclusion provision in spite of the equity issues involved, it might want to at least consider some of the options discussed in the report. They include:
- Disallow the exclusion for debt forgiveness income where the debt is a home equity line of credit ;
- Provide a cap on the amount of cancelled debt income that can be excluded
- Provide a cap on income eligibility for the provision
Disallowing the income exclusion for home equity indebtedness seems critical to the fairness of any provision for relieve. Home equity loans are frequently taken out to fund general personal consumption. If only homeowners can enjoy the exclusion for personal consumption debt, it raises a serious equity issue. Similarly, use of a cap for the debt cancellation income exclusion would provide some assurance that the provision would not act as an incentive to irresponsible borrowing. Finally, the income cap for eligibility for the provision is essential. The exclusion should be limited to lower-income taxpayers who would likely suffer the most financial distress from the added tax burden.
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