Short sale tax relief is free money to HELOC abusers
Many borrowers spent their home equity during the housing bubble, and now they want income tax relief on the money they spent as income.
Mortgage equity withdrawal feels like free money. When this money comes from home-price appreciation on a primary residence, the borrower did nothing to earn this money, and since a primary residence has a large capital gains tax exclusion, the borrower won’t pay any taxes, income or capital gains, on free money they extract from their house. Obviously, this makes mortgage equity withdrawal a very desirable source of spending money.
Of course, borrowed money is not free money, and it must be repaid. Most HELOC abusers expected the house to pay off this bill for them, but when house prices crashed, the house wasn’t cooperating, and most HELOC abusers found themselves without enough value in their house to pay the bills. They faced the terrifying and disheartening prospect of repayment from their money, either from wages or other investments, clearly not their plan.
Despite rising home prices, many borrowers are underwater on their mortgages. Some of these borrowers were unfortunate with their timing, and they are underwater due to an ill-timed purchase. I would support short-sale tax relief for those borrowers; however, a significant number of underwater borrowers face their circumstances due to their irresponsible borrowing and profligate spending — those borrowers should not get any kind of relief because for them the borrowed money was income.
Unfortunately, in the public discourse on this issue, the important distinction between bad timing and bad behavior is seldom mentioned. Everyone wants to save the borrower who had bad timing, but no effort is being made to exclude the irresponsible fool.
David Foster, who sold his condo in Chicago last month, isn’t plugged in to Capitol Hill’s political games. But he has banked the financial future of his family on Congress accomplishing at least one thing during the post-election session: renewing the expired Mortgage Forgiveness Debt Relief Act so that he and his wife and three young children aren’t crushed by taxes next year on the $100,000 his lender agreed to cancel as part of a short sale.
Like thousands of other owners across the country who have been struggling with underwater properties, Foster, a 33-year-old campus pastor with a local ministry group, knew he was taking a risk when he negotiated the short sale and debt cancellation.
A pastor with a local ministry group? Do you think this borrower was selected for the obvious sympathetic attachment to his irrelevant occupation?
In a short sale, the lender allows a new purchaser to buy a house at a price below the mortgage amount owed by the seller. As part of the deal, the lender typically forgives the unpaid balance.
The risk Foster took was this: If the Senate and House do not pass an extension of the mortgage debt relief law during the lame-duck session, the full principal balance his lender wrote off on his mortgage probably will be treated as ordinary income for 2014. Although Foster never received a dollar of that “income” in his wallet, under the federal tax code he’ll owe a tax payment to the government — $28,000 — on the $100,000 his lender wrote off.
“I don’t know how or where we could come up with that,” Foster told me. “I can’t believe anyone would think this is a reasonable thing to do” — hit underwater home sellers with heavy tax bills while they’re still struggling to recover from their own financial crises.
Mr. Foster, I think it’s a very reasonable thing to do, perhaps not to people like you who timed the market poorly, but to all the HELOC abusers who gamed the system well.
That is precisely the issue now before the House and Senate — whether to extend for one more year a temporary tax relief provision expressly designed for homeowners such as Foster.
It took effect in 2007 as foreclosures began to mount across the country and millions of people fell behind on mortgage payments. Then came the bust in 2008. Then the Great Recession, which hasn’t really ended for many families.
The mortgage debt relief law expired Dec. 31, along with other special-interest tax breaks that usually would have been renewed as a package. That process broke down last year, however, leaving people who have received principal debt reductions during 2014 — whether through short sales, loan modifications or foreclosures — twisting in tax limbo.
Everyone who received principal reductions of any kind should be subject to the same criteria: if they were victims of poor timing, if it was a purchase-money mortgage, then they deserve a break; however, it they are victims of their own ineptitude, if they extracted cash, then they deserve to pay the tax bill.
In Foster’s case, a condo he purchased for $202,000 in May 2008 began to plunge in value almost immediately, as did many others in the greater Chicago area. By the time of his short sale last month, the bank concluded the most it could get for the condo was $50,000, which an investor agreed to pay. Yet Foster’s remaining loan balance was about $150,000, two-thirds of which the bank wrote off.
He should get a break, but the HELOC abuser in his circumstances should pay taxes on $150,000 in income.
Last summer, the mortgage debt relief extension appeared to be moving ahead in the Senate. In a bipartisan vote, the Finance Committee approved what became known as the EXPIRE Act. Along with a package of other short-term tax benefits, the bill extended the mortgage debt relief provisions through December 2015.
Sen. Ron Wyden (D-Ore.), chairman of the committee, sent the bill to Majority Leader Harry Reid (D-Nev.) for floor debate and a vote. But Reid barred it from the legislative schedule when Republicans insisted on adding an amendment to the package that would repeal an excise tax that funds the Affordable Care Act.
Reid said he would consider allowing a vote on the EXPIRE bill only during the lame-duck session after the midterm elections.
So here we are. Reid has indicated that the extenders bill should get a vote. Most Capitol Hill experts say there’s a good chance the bill will pass.
On the House side, the outlook is muddier. Rep. Dave Camp (R-Mich.), chairman of the Ways and Means Committee, opposes piecemeal extensions of tax breaks. He favors comprehensive tax reform, with no temporary extenders, as do many of his Republican colleagues.
Where’s this headed? No one can yet say for sure, but Alexis Eldorrado, the Chicago realty broker who helped Foster accomplish his short sale, says Congress needs to find a way to do the right thing for thousands of financially pressed owners. To fail to pass one more extension, she says, “would be unconscionable.”
In all likelihood, this bill will die, and these borrowers will get hit with a tax bill. Of course, if they are truly insolvent, they can claim insolvency with the IRS and avoid paying the tax; however, if they have assets, they will be forced to sell those assets or work out a payment plan for their back taxes.
If taxes on forgiven debt strikes people with purchase-money mortgages, it’s a bad break. If this happens to HELOC abusers, it’s justice served.