Federal Tax Policy’s Challenge to Mortgage Restructuring
Special Studies, November 8, 2007
By Robert D. Dietz, Ph.D.
Report available to the public as a courtesy of HousingEconomics.com
The weakened state of the housing market has resulted in record inventory of new and existing homes for sale. This large inventory of homes has produced softening prices, which has increased the difficulty for prospective buyers to sell an existing home in order to trade up to a new residence. Moreover, the problems in some parts of the mortgage market, such as subprime and Alt-A, have resulted in a tightening of credit availability, as seen in increased credit standards and reduced mortgage availability. These factors have created challenges for some prospective buyers, particularly buyers in markets where there have been financing challenges. Furthermore, the inventory of unsold homes is further swelling due to sharp increases in mortgage foreclosures.
The problem of foreclosures and the resulting increase in inventory is a growing issue in the housing market. According to data from the Mortgage Bankers Association National Delinquency Survey, the percentage of homes nationwide in foreclosure has increased by 38% from the first quarter of 2004 to the third quarter of 2007. Housing markets are inherently local, and the challenges of foreclosure tend to be concentrated in certain areas. For example, over this time period, foreclosures were up over 300% in California and over 150% in Nevada, Massachusetts, and Minnesota. The baseline level of foreclosures is highest in the industrial Midwest, with Michigan having 1.07% and Ohio 1.03% of all homes in the foreclosure process. Additional foreclosure waves are on the horizon, as the heavy volume of adjustable rate mortgages (ARMs) originated at low “teaser” initial interest rates in 2005 and 2006 reset to much higher payment levels over the next two years.
In response to these mounting pressures, the Department of the Treasury has coordinated an alliance of mortgage industry participants called HopeNow.com. The goal of the alliance is to provide foreclosure prevention counseling and to coordinate mortgage restructuring or “workouts” as increasing numbers of mortgages reset to higher payments. Approximately 1.3 million subprime adjustable rate mortgages are due for rate resets between the 3rd quarter of 2007 and the end of 2008. Recently, the nation’s largest mortgage lender, Countrywide Financial, has announced that it will restructure or refinancing $16 billion in resetting ARMs.
However, 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. For homeowners 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. To prevent this tax from applying to homeowners and lenders seeking to restructure existing mortgages, Congress must modify the nation’s tax code.
The Tax Consequences of Debt Forgiveness
Under present law, debt forgiveness counts as income for tax purposes. Because no actual cash is received by the borrower when debt is forgiven, this is an instance of tax code requiring tax on phantom income. In particular, Section 108 of the Internal Revenue Code requires all discharges of indebtedness to be included in gross income. The regulations for this section of the tax code (Treasury Income Tax Regulations Section 1.1001-3) require that interest rate reductions of more than 25 basis points also give rise to discharge of indebtedness income and therefore produce tax liability. However, Section 108 provides an exclusion from these requirements for taxpayers who are insolvent or are subject to Title 11 bankruptcy proceedings.
For homeowners struggling to make their mortgage payments, this tax consequence can take several forms, depending on the type of mortgage they hold and the situation in which the debt is reduced or forgiven. 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.
For example, suppose a homeowner has an existing mortgage balance of $200,000 and faces a marginal tax rate of 28%. The homeowner fails to make mortgage payments, and in response the lender determines that a small amount of principal forgiveness is preferred to foreclosure of the property. This action is sometimes referred to as a loss mitigation action and is often in the best interest of the lender as the foreclosed home is worth less than the fair market value of the home. Lenders do not want to be landlords and therefore are often willing to make concessions to bring a loan current in payments.
Suppose the lender forgives $20,000 of the outstanding principal, thereby reducing the required mortgage payment to a level that facilitates ongoing payment. Under existing tax rules, the IRS concludes that the debt forgiveness increases the homeowner’s wealth by $20,000 due to the loss mitigation action of the lender, producing a corresponding increase in taxable income of $20,000. Given the 28% tax rate, the homeowner has federal tax liability of $5,600. In many states, the homeowner owes state income taxes as well.
Tax liability can also arise in the case of foreclosure. Suppose that the homeowner has an outstanding mortgage principal of $200,000 and experiences foreclosure on the home. Further suppose that the home’s fair market value is less than the existing mortgage balance. If the lender has the right to pursue other assets of the homeowner to collect the difference but forgoes this legal right, then the difference between the price of the house and existing mortgage balance is considered forgiven debt. Suppose the home is sold for $190,000. The revenue from the sale allows the homeowner to repay $190,000 of the mortgage, but this leaves $10,000 of unpaid debt. If the lender forgives this amount, then the homeowner has a tax liability of $2,800 or more. This tax outcome can also occur if the lender agrees to let the homeowner sell and forgives the remaining debt. This is sometimes referred to as a “short sale.” Another course of action that can result in debt forgiveness and tax liability for the borrower is the situation in which the homeowner transfers ownership to the lender to avoid foreclosure. This action is called “deed in lieu of foreclosure.”
Recourse and Non-recourse Debt
Mortgages are classified as either recourse or non-recourse debt. For tax purposes, recourse debt is defined as any type of debt instrument for which the borrower possesses personal liability for repayment. Most mortgages in the United States are recourse debt for tax purposes. However, some states, such as California, place a number of statutory restrictions on what rights the lender has with respect to pursuing other assets of the borrower in the case of nonpayment. These restrictions usually take the form of anti-deficiency statutes that prevent lenders from seizing other assets of the borrower. It is not entirely clear how strong these anti-deficiency clauses have to be for the IRS to treat the mortgage as non-recourse. For example, in 1991 the IRS issued a private letter ruling noting that despite certain Alaskan anti-deficiency rules, mortgages issued in the state were recourse debt for tax purposes. Private letter rulings are agency opinions and are not binding as a matter of law, but this private letter ruling suggests that whether a mortgage is recourse or non-recourse is a complicated facts-and-circumstances evaluation.
The previous examples demonstrated the tax impacts from restructuring or forgiveness of recourse debt. For non-recourse debt, the tax treatment is slightly different. In the case of a restructuring, the cancellation of debt is treated as Section 108 income and is subject to ordinary income tax rates, as illustrated above. However, in the case of a foreclosure, the forgiven non-recourse debt amount is treated as a capital gain. This is due to the fact that in this context there is no personal liability to repay the debt, so there is no wealth effect per se that results from debt forgiveness.
For example, suppose a homeowner facing foreclosure has an outstanding mortgage of $200,000, but the cost basis of the residence (in general, the original purchase price of the home) is equal to $220,000. The net capital gain from the sale is equal to outstanding debt minus the cost basis or $20,000. Note that the actual sale price of the home is irrelevant in this case because the “return” or gain is not the sale of the property, which is surrendered, but rather the disposal of the debt net of the basis of the property.
For most capital assets, individuals face a 15% long-term capital gains tax rate for assets held longer than one year. However, if the home is a principal residence, then the principal residence gain exclusion amounts may preclude tax payment. Section 121 of the tax code provides a $250,000 exclusion of gain for the sale of principal residence to single taxpayers and a $500,000 gain exclusion for joint returns. Section 121 defines a principal residence as a home used as the primary legal residence for two years out of the five years prior to sale or exchange of the home. Assuming that the Section 121 rules are satisfied, the homeowner in the non-recourse case in most cases faces no additional tax liability as a result of the foreclosure.
The Economics of Present Law
The tax rules described above create an unfair and odd set of consequences for struggling homeowners. First, for most homeowners, 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. Homeowners 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 mitigations efforts, thereby increasing the probability of foreclosure.
Second, for non-recourse mortgage holders, the existing tax rules create a significant incentive for homeowners to prefer foreclosure over mortgage restructuring. Clearly, the lender prefers to continue to receive payment on the mortgage rather than initiate the foreclosure process. However, for the non-recourse case, the homeowner receives a tax bill from the IRS for restructuring the mortgage but is generally exempt from tax in the event of foreclosure because of the principle residence gain exclusion rules. This means the homeowner has little incentive to participate in loss mitigation activities and may instead prefer to mail in the keys and walk away from the home.
In addition to the financial damage this does to the homeowner and the lender, it also results in additional homes-for-sale on the market, thereby placing additional pressure on local prices and increasing supply competition for new homes. Moreover, the Section 108 tax rules do not apply to borrowers who are insolvent or bankrupt, so the rules generally only apply to mortgage restructuring cases. As a consequence, the present-law tax rules obstruct lenders and struggling homeowners from restructuring mortgages in both the non-recourse and recourse cases, which is the preferred market-based solution to this aspect of the on-going dislocations in the housing credit market.
Proposed Legislative Solution
To fix these flawed tax rules, members of Congress and President Bush have proposed modifying Section 108 of the tax code. The proposals create an exemption from the discharge of indebtedness tax for any debt forgiveness associated with a principal residence.
The intent of these proposals is not to bail out those who abused the housing finance system in recent years. In particular, these bills do not bail out debt held by speculators. Further, the proposals do not provide relief to homeowners who are unable to make payments on home equity loans. The congressional proposal also includes a recapture provision. [3]
Homeowners are required to reduce the tax basis of their homes by the amount of the exempted forgiven debt, thereby increasing their capital gains tax bill in the future if the home is sold for a gain. However in practice, this recapture provision will produce little revenue because of the Section 121 principal residence gain exclusion. The congressional proposal also contains other safe guards to prevent abuse of the exemption, such as rules preventing lending firms from using debt forgiveness as a payment (tax-free under the proposal) for services.
If enacted into law, the mortgage debt tax forgiveness would significantly improve the feasibility of market-based actions to prevent foreclosure. For holders of recourse mortgages, such tax relief would encourage market-based workouts. For holders of non-recourse mortgages, the effects would be even stronger, as the existing system taxes workouts but effectively leaves foreclosure as a non-tax event. More workouts and fewer foreclosures mean fewer homes on the market, which is good for homeowners, builders and communities.
The congressional proposal also contains an eight-year extension of the private mortgage insurance (PMI) deduction, presently set to expire at the end of 2007. Under present law, Section 163(h)(3)(E) treats PMI, Veterans Administration, and Federal Housing Administration, and Rural Housing Administration mortgage insurance payments as deductible amounts, similar to mortgage interest payments, for mortgage insurance issued after January 1, 2006. However, the deduction is subject to an income phase-out that precludes this deduction for married taxpayers with an adjusted gross income of more than $110,000. Nonetheless, the extension of the PMI deduction will encourage homeowners to obtain less risky mortgage products thereby reducing the need for loss mitigation efforts in the future. The provision will also have a long-run benefit on government revenues, as the flow of deductible mortgage interest payments will be smaller with more PMI participation, as this reduces the use of higher interest second-liens or so-called piggyback mortgages.
In total, these proposals would benefit the housing market by keeping homeowners in their homes, limiting the amount of housing inventory on the market, and helping to check further housing price declines. These outcomes would be positive for homeowners, home builders and the U.S. economy as a whole.
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