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Tax on Forgiven Mortgage Debt Hits Home Owners While Down
Ongoing efforts in the housing finance industry to keep home owners from losing their homes, limit the amount of inventory returning to the market and help check further housing price declines are being hampered by federal tax law that legislators on Capitol Hill are attempting to change, according to NAHB economist Robert Dietz.
“The Internal Revenue Service treats all debt amounts that are reduced, forgiven or eliminated as part of a mortgage restructuring or foreclosure as taxable income,” Dietz writes in a special study for NAHB Housing Economics.
“For home owners struggling to make their regular mortgage payments, this phantom income taxation creates a disincentive against restructuring an existing mortgage to ensure continued payment and avoid foreclosure,” he says. “To prevent this tax from applying to home owners and lenders seeking to restructure existing mortgages, Congress must modify the nation’s tax code.”
H.R. 3648, the Mortgage Forgiveness Debt Relief Act of 2007, which would eliminate the tax consequences associated with debt forgiveness, has been approved by the House of Representatives.
With the exception of taxpayers who are insolvent or subject to Title 112 bankruptcy proceedings, Section 108 of the Internal Revenue Code requires all discharges of indebtedness to be included in gross income, including interest rate reductions of more than 25 basis points.
Looking at the tax consequences, Dietz says that in the typical case “the lender forgives a portion of an outstanding mortgage principal or reduces the interest rate. The forgiven debt is considered income and is taxed at ordinary income tax rates of up to 35%. In the case of a reduced interest rate, the amount of forgiven debt is equal to a calculation of the reduced present value of the debt due to the reduction of the interest rate.”
Some examples cited by Dietz of how the tax could hit distressed borrowers:
- Taking a “loss mitigation action,” a lender decides to forgive $20,000 of an existing mortgage balance of $200,000 in order to help a delinquent home owner catch up on payments and avoid foreclosure. The IRS views this as a $20,000 increase in the home owner’s taxable income, and at a marginal tax rate of 28% federal tax liability is increased by $5,600. In many states, the home owner will owe additional income taxes to the state as well.
- A lender decides to foreclose on a home with a fair market value of less than the outstanding mortgage principal of $200,000 and foregoes its legal right to pursue other assets of the home owner to collect the difference. In this case, the IRS considers the difference between the selling price of the house and the existing mortgage balance as forgiven debt. If the home is sold for $190,000, the owner is left with $10,000 of unpaid debt after using the proceeds to pay down the mortgage. If the lender forgives this amount, then the home has a tax liability of $2,800 or more.
Current tax rules “create an unfair and odd set of consequences for struggling home owners,” Dietz says.
For most home owners who hold recourse mortgages, “the application of a tax on foreclosure represents a ‘hit them while they’re down’ tax on phantom income that violates the general tax policy principle of assessing tax liability according to ability-to pay,” Dietz says. “Home owners facing foreclosure are not experiencing a cash or liquid asset windfall, so most tax analysts would agree that the tax is punitive and unfair. The tax on restructuring also discourages loss mitigation efforts, thereby increasing the possibility of foreclosure.”
Proposals by members of Congress and President Bush to exempt from the discharge of indebtedness tax any debt forgiveness associated with a principal residence “would significantly improve the feasibility of market-based actions to prevent foreclosure,” Dietz says.
To read more in NAHB's HousingEconomics.com, click here.
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