The economic crisis began with the housing crisis, and it will only end when the housing crisis also ends. Unfortunately, the evidence of the past five years suggests that the Obama administration and Congress have never actually understood this connection. Despite massive numbers of foreclosures, the loss of almost $7 trillion in housing wealth (over one-half the nation’s home equity), and even unprecedented pleas from the Chairman of the Federal Reserve, there has been a shocking paucity of innovation or even policy activity in the housing arena.
Now there is a a very real chance that Congress will destroy the limited policies the Obama administration does have in place, prevent additional efforts, and further widen the gap between the haves and have-nots in America. Moreover, the net effect of this congressional failure could be to further undermine the weak housing market and risk sending the nation into another economic tailspin.
The administration’s signature housing policy effort is now aimed at mortgage principal reductions. This effort is at the core of the multi-state robo-mortgage settlement and central to the administration’s criticism of Edward DeMarco, the acting director of the Federal Housing Finance Agency. From the perspective of many analysts, myself included, the administration is finally on the right track, but its efforts are far too minimal to make a meaningful difference. Indeed, the nation’s total negative equity (the amount of mortgage debt owed which exceeds the value of the underlying properties) is presently in the range of $700 billion, and it’s likely to increase.
Nonetheless, the administration’s principal reduction efforts are a step in the right direction. These efforts open the door for the far larger, far more creative efforts that will ultimately be needed to prevent millions of upcoming foreclosures and possibly massive walk-aways from the estimated 23 percent (and increasing) of all mortgage holders — 11 million families — who are underwater.
Here’s the issue: As a general rule, any debt forgiveness is income. This means that if a home buyer borrows to buy a house and the bank forgives a portion of the loan, whether in a short sale, through debt reduction (i.e. the settlement), or even foreclosure in states that allow banks to officially choose not to seek recourse, a taxable event has occurred. The income earned is the difference between the original mortgage borrowed and the amount ultimately repaid to the bank.
For example: A family borrows $300,000 for a mortgage. The home declines in value and the bank agrees to a short sale (where the sale price is for less than the amount of the homeowner’s mortgage debt) and receives a total pay-off of $200,000. The $100,000 difference between the amount borrowed and the amount ultimately paid back is the amount of the loan the bank has forgiven. This $100,000 is a type of principal reduction and generally subject to ordinary income taxes.
However, at the start of the housing crisis in 2007, Congress enacted the Mortgage Forgiveness Debt Relief Act of 2007, which exempts precisely this phantom income from federal taxation. The term of the law was extended in 2008. But the current law expires at the end of 2012, and it is by no means clear that it will be extended. Moreover, the seeming lack of public discussion about the need to extend it is shocking.
(There are a complex array of qualifying circumstances and exemptions surrounding this tax issue, including the laws of the individual state involved, the solvency of the homeowner, whether the homeowner is in bankruptcy, whether the sale involves a primary residence, refinancing associated with the property, and a variety of other factors related to qualifying for the federal exemption. In particular, short sales in nonrecourse states (which include California) are not considered debt forgiven and therefore, if no other income-generating activities apply, do not trigger federal taxes. But this article does not address the many nuances involved in these issues.)
It’s virtually impossible to imagine that struggling families who are selling underwater homes at a large loss (and have already lost a large chunk of their life savings as the value of their home equity, including their down-payment, was vaporized in the housing crisis) will go forward with short sales. The vast majority of homeowners will not be able to afford the resulting tax debt. So one consequence of a failure to extend this law is likely to be an immediate end to the vast majority of short sales, which have been increasing rapidly. Short sales constituted an estimated 24 percent of all January 2012 home sales and surpassed the estimated 20 percent of all January sales comprised of foreclosed homes.
For the same reasons, all efforts at principal reduction will be stopped cold at the end of this year.
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