Mortgage Double Whammy: First, Ever, Suffers from Two Serious Defects

Mortgage Double Whammy: First, ever, suffers from two serious defects. First, it is not retroactive and therefore would not help homeowners You Default; Second, You’re Taxed who default before the legislation’s effective date.7 Sec- ond, it covers only acquisition debt incurred to acquire, By Stephen B. Cohen construct, or improve a home and omits home equity debt financed by postacquisition appreciation in a home’s value.8 Stephen B. Cohen is a professor of law at George- Nevertheless, the Supreme Court’s holding in Bowers town University Law Center. He is deeply grateful to v. Kerbaugh-Empire Co.9 — that forgiveness of debt causes Ken Bacon, Dan Halperin, Laura Sager, and Ethan Yale income only if the transaction as a whole produces an for their comments on an earlier draft. Cohen is also overall gain — may prevent taxation even if corrective indebted to Ellen Harnick of the Center for Respon- legislation with retroactive effect and broader coverage is sible Lending for educating him about the subprime not enacted. This article discusses the code provisions mortgage crisis. that cause the tax on defaulting homeowners and then considers how Kerbaugh-Empire may eliminate the tax.10 Copyright 2007 Stephen B. Cohen. All rights reserved. I. How the Tax Arises The tax arises when a homeowner defaults and the mortgage debt exceeds the market value of the home. As the subprime mortgage crisis deepens, more and Until recently, an excess of mortgage debt over home more homeowners default on their mortgages and face value was a much less frequent occurrence. Responsible what The New York Times calls a ‘‘double whammy.’’1 mortgage lenders historically have required a significant ‘‘First, they lose their homes; then they get billed for taxes equity cushion, for example 15 percent or more, before on the amount of debt...wiped away in foreclosure.’’2 making a mortgage loan. The mortgage debt can then Another observer describes the double whammy as ‘‘a exceed the home’s value only if that value declines by 15 tax that kicks debtors when they’re down,’’ and then she percent or more, and for nearly the entire period since the asks rhetorically, ‘‘How can I possibly owe tax when I’m Depression, home prices in most regions have steadily making no profit and losing ...myhome?’’3 risen.11 The Center for Responsible Lending, a nonpartisan Nevertheless, during the past decade, mortgage lend- research center, estimates that 2.2 million subprime loans ers have aggressively marketed mortgages requiring an made in recent years have already failed or will end in equity cushion of only 5 percent or less of a home’s foreclosure,4 and a significant fraction of the defaulting value.12 If a home’s value increases or at least remains homeowners may be subject to the tax. A bipartisan stable, then, even with a mortgage of 95 percent to 100 congressional coalition — supported by President Bush percent of a home’s value, the mortgage debt will not — is sponsoring legislation amending the Internal Rev- exceed that value. In the past two years, however, home enue Code to stop this tax on the ‘‘phantom income’’5 of defaulting homeowners.6 The proposed legislation, how-

support in both houses. See http://www.govtrack.us/cong ress/bill.xpd?bill=h110-1876&tab=summary. 1Editorial, ‘‘Foreclosure and Taxes,’’ The New York Times, Aug. 7Id. 24, 2007. 8Id. 2Id. 9271 U.S. 170 (1926). 3Kathy Kristof, ‘‘Tax Relief May Be Coming for Those Facing 10A defaulting homeowner might use those precedents to Foreclosure,’’ The Morning Call, Sept. 7, 2007. challenge the tax, perhaps with the assistance of a public interest 4Ellen Schloemer, Wei Li, Keith Ernst, and Kathleen Keest, group. Alternatively, the National Taxpayer Advocate, an inde- ‘‘Losing Ground: Foreclosures in the Subprime Market and Their pendent office within the IRS charged with protecting taxpayer Cost to Homeowners,’’ p. 3 (Dec. 2006), available at http:// interest, might issue a legal opinion affirming that the judicial www.responsiblelending.org/issues/mortgage/reports/. precedents discussed below prevent the tax. 5See http://www.realtor.org/press_room/news_releases/20 11See data collected and summarized by the U.S. Census 07/nar_says_eliminating phantom_tax.html. Bureau, available at http://www.census.gov/hhes/www/ 6See http://www.whitehouse.gov/news/releases/2007/08/ housing/census/historic/values.html. 20070831-4.html. Sen. Debbie Stabenow, D-Mich., introduced 12Some lenders even offer loans that exceed a home’s value the Mortgage Cancellation Relief Act of 2007, S. 1394, available at by a significant amount. See, e.g., the advertisement at http:// http://www.govtrack.us/congress/billtext.xpd?bill=s110-1394. www.noequity.com/no-equity-loans.htm, in which NoEquity. Rep. Robert Andrews, D-N.J., introduced the same bill, H.R. com offers to provide a loan of up to 125 percent of the value of 1876, in the House. The bill has attracted broad bipartisan the borrower’s home. (Footnote continued in next column.)

TAX NOTES, October 8, 2007 169 COMMENTARY / VIEWPOINTS values in many regions have declined.13 Those two which (for reasons explained below) effectively prevents factors combined — mortgage lending with a small or the tax from being imposed. (C) Tax Analysts 2007. All rights reserved. does not claim copyright in any public domain or third party content. nonexistent equity cushion plus declining home values To illustrate the application of the forgiveness of debt — mean that when homeowners default, their mortgage rule to default and foreclosure on an ordinary recourse debt may — much more frequently than in the past — home mortgage, consider the following example. In 2005 exceed the value of their homes. a home is purchased for $100,000, with 95 percent of the Mortgage debts in excess of home values now appear purchase price financed by a $95,000 home mortgage to be widespread. According to one study, 10 percent of loan. Home prices decline, and in 2007 the home is worth homeowners with a mortgage had zero or negative only $90,000, while the unpaid mortgage principal at the equity in their homes as of September 2005, 29 percent of end of two years is $94,000.18 If the homeowner defaults homeowners who bought or refinanced in 2005 had zero at that point, the lender forecloses and the $94,000 unpaid or negative equity, and 15.2 percent of those homeowners mortgage debt exceeds the $90,000 value of the house, so had a negative equity of 10 percent or more of the home’s there is $4,000 of forgiveness of debt income on which tax value.14 is due, assuming the lender has given up trying to collect Enter the tax code. A bedrock principle of taxation is the excess. that income arises when a borrower pays back a loan for Something is missing, however, from the tax law’s less than the full amount owed.15 The excess of the account of the foreclosure in this example as producing a amount owed over the amount repaid — the forgiven gain equal to the excess of the mortgage debt over the debt — constitutes an economic gain. Since at least 1931 home’s value: the fact that the home has declined in the economic gain resulting from forgiveness of indebt- value — from $100,000 to $90,000 — so that there is a edness has been considered by the courts as taxable $10,000 loss on the home, which more than offsets the income,16 and in 1954 Congress codified in section $4,000 gain from forgiveness of part of the mortgage 61(a)(12) the rule that forgiveness of debt produces debt. Section 165(c) prohibits individuals from deducting income. losses on property held for personal consumption. Al- That rule is the source of the so-called double- though many homeowners may consider their homes whammy tax. When a homeowner defaults on home both a personal consumption item and an investment, mortgage debt, the mortgage lender forecloses and the owner-occupied housing is treated as falling into the debt is in effect repaid with the home. If the mortgage personal consumption category.19 A home constitutes debt exceeds the home’s value — as is increasingly the business or investment property for tax purposes only if case with subprime mortgages as housing prices decline rented to someone other than the owner and not occu- — the debt is not repaid in full and the forgiveness of pied by the owner.20 debt produces income under section 61(a)(12).17 Thus, the double-whammy tax arises because of the That conclusion — that mortgage default produces combined effect of two separate code provisions. First, forgiveness of debt income under section 61(a)(12) when forgiveness of debt produces income when the mortgage the mortgage debt exceeds the home’s value — is subject debt exceeds the market value of the home. Second, the to two qualifications. First, there is forgiveness of debt decline in the value of the home produces a real eco- income only if the mortgage lender does not try to collect nomic loss, but it is a loss for which the code prohibits the excess of the unpaid mortgage debt over the value of any deduction. The tax arises, in other words, because the the house. If the lender does try, the excess amount is not excess of the mortgage debt over the home value consti- forgiven unless and until the mortgage lender gives up tutes income from forgiveness of debt under section trying to collect the excess. Second, forgiveness of debt 61(a)(12), whereas the loss in the home’s value cannot be income can arise on foreclosure only if the mortgage is an deducted because of a prohibition in section 165(c).21 ordinary recourse mortgage on which the borrower is The code does provide an escape for defaulting home- personally liable, rather than a nonrecourse mortgage for owners in especially precarious financial circumstances. which there is no personal liability. If the mortgage is If the homeowner is bankrupt or insolvent, section nonrecourse, the excess of the mortgage debt over the 108(a)(1)(A)-(B) provides that forgiveness of debt income home’s value is treated as an amount paid for the home, is not subject to taxation.22 Otherwise, the ‘‘mechanical application’’23 of sections 61(a)(12) and 165(c) appears to cause the tax.

13See, e.g., Kimberley Blanton, ‘‘Home Prices Fall for Fif- teenth Month,’’ The Boston Globe, Aug. 22, 2007, available at http://www.boston.com/business/globe/articles/2007/08/22/ 18The example assumes that from 2005 through 2007, mort- home_prices_fall_for_15th_month/?page=2. gage payments go almost entirely to cover interest accruing on 14The study was performed by First American Real Estate the loan, so that only $1,000 of the mortgage principal amount Solutions (now First American CoreLogic), an arm of First has been paid off by 2007. American Corp., a title insurance company, and is referred to at 19See, e.g., Gevirtz v. Commissioner, 123 F.2d 707 (2d Cir. 1941). http://moneycentral.msn.com/content/Banking/Homefinanci 20Id. ng/P148861.asp. 21Moreover, even if the loss were deductible, it would 15See generally Boris I. Bittker, Martin J. McMahon Jr., and constitute a capital loss, which could generally not be used to Lawrence A. Zelenak, Federal Income Taxation of Individuals,3d offset ordinary income, including income arising from forgive- ed. (2002), pp. 4-19 to 4-20. ness of debt. See sections 1211(b) and 1221. 16United States v. Kirby Lumber, 284 U.S. 1 (1931). 22Section 108(a)(1)(A)-(B). 17Reg. section 1.1001-2, Example 8. 23Bradford v. Commissioner, 233 F.2d 935, 939 (6th Cir. 1956).

170 TAX NOTES, October 8, 2007 COMMENTARY / VIEWPOINTS

II. The Kerbaugh-Empire Principle assumed the debt and therefore, considering the transaction as a whole, had no gain.28 (C) Tax Analysts 2007. All rights reserved. does not claim copyright in any public domain or third party content. There are judicial precedents that express disdain for The court cited Kerbaugh-Empire as ‘‘authority for the ‘‘mechanical application’’ of the code and hold that proposition that in deciding the income tax effect of forgiveness of debt produces income only if the transaction cancellation of indebtedness for less than its face amount, as a whole actually produces an overall gain. Those prece- a court need not in every case be oblivious to the net dents may seem ancient; the principal Supreme Court effect of the entire transaction.’’29 case is over 80 years old. They nevertheless imply that In 1962 the Tenth Circuit in United States v. Hall30 the defaulting homeowner in the example above — who approvingly cited both Kerbaugh-Empire and Bradford in does not have an overall gain from the transaction ruling that forgiveness of debt was not income because because the loss in the home’s value exceeds the gain the transaction in question did not produce an overall from forgiveness of debt — may not be subject to tax even profit. though the mortgage debt exceeds the home’s value on Courts need not apply mechanical standards which foreclosure. smother the reality of a particular transaction. Bow- In Bowers v. Kerbaugh-Empire Co.,24 a 1926 Supreme ers v. Kerbaugh-Empire Co. [citations omitted] The Court decision, the taxpayer repaid a loan for $685,000 Sixth Circuit in a recent case [Bradford] remarkably less than the amount borrowed. While the repayment similar in principle to the case at bar had occasion appeared to produce a $685,000 gain, the Court noted to consider the Kerbaugh-Empire Co. case and sub- that the borrowed funds had been entirely lost in unsuc- sequent authorities and concluded, as do we, that cessful business ventures during 1913-1918 and that the the film of technicality should not be allowed to losses exceeded the taxpayer’s other income during those support a colorable profit.31 years by more than $685,000. Considering the transaction One court of appeals has declined to follow the as a whole, the business losses incurred on the use of the transactional approach of Kerbaugh-Empire. In 1986 the funds exceeded the forgiveness of debt gain on repay- Ninth Circuit in Vukasovich v. Commissioner32 referred to ment of the loan in 1921.25 Consequently, there was no Kerbaugh-Empire as ‘‘an obviously outdated Supreme income to report. Court decision’’33 and held that a taxpayer had income on the forgiveness of debt even though losses incurred in the Five years later, in 1931, in United States v. Kirby Lumber use of the loan exceeded the amount of the forgiven Co.,26 the Supreme Court held that the repayment of a debt.34 debt for less than the full amount owed did produce forgiveness of debt income but specifically distinguished The most recent court of appeals decision to consider Kerbaugh-Empire by asserting that there were no offsetting the transactional approach of Kerbaugh-Empire has been losses and therefore that the transaction as a whole did considerably more respectful. In 1990 the Third Circuit, in produce a gain. A leading federal income taxation treatise observes:

28 Kerbaugh-Empire linked the tax treatment of the 233 F.2d 935. For a critique of Bradford’s conclusion that the debt discharge to the fate of the borrowed funds, assumption of the debt in this case produced a loss, see Stephen and Kirby Lumber carried forward this idea by B. Cohen, ‘‘The Tax of Physics, The Physics of Tax,’’ 3 Green Bag 2d 375 (2000). distinguishing rather than repudiating Kerbaugh- 29233 F.2d at 939. Empire, seeming thereby to sanction an open- 30307 F.2d 238 (10th Cir. 1962). ended inquiry into the debtor’s financial history to 31Id. at 241. Note that Hall uses the word ‘‘colorable’’ in the determine whether the discharge of the debt gen- sense of ‘‘counterfeit’’ or ‘‘appearing to be reasonable or true, erated a ‘‘clear gain.’’27 but in fact being neither.’’ 32790 F.2d 1409 (9th Cir. 1986). In 1956, 25 years after Kirby Lumber, the Sixth Circuit 33Id. at 1416. held in Bradford v. Commissioner that forgiveness of a 34Following Vukasovich, the IRS issued Rev. Rul. 92-99, 1992-2 $50,000 debt did not produce income because the tax- C.B. 35, which described Kerbaugh-Empire as a ‘‘discredited’’ payer had assumed the debt (originally incurred by her decision and announced that the IRS no longer considered the husband) without receiving anything in return. The court decision to be good law. Both Vukasovich and Rev. Rul. 92-99 claimed that the decision was logically inconsistent with later concluded that the taxpayer had a $50,000 loss when she Supreme Court decisions in Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955), United States v. Kirby Lumber Co., 284 U.S. 1 (1931), and Commissioner v. Tufts, 461 U.S. 300 (1983). Preslar v. Commissioner, 167 F.3d 1323, Doc 1999-6438, 1999 TNT 32-6 (10th 24271 U.S. 170 (1926). Cir. 1999), also referred in passing to Kerbaugh-Empire as ‘‘a 25Id. at 175. The loan was extended in German marks, decision implicitly repudiated in subsequent years.’’ 916 F.3d at converted in dollars, and repaid in German marks. The taxpayer 1332. However, the eminent Tax Court judge Theodore Tannen- was able to repay the loan with devalued marks, and therefore wald Jr. expressed a contrary view in his dissenting opinion in the gain, strictly speaking, was not attributable to forgiveness of Zarin v. Commissioner, 92 T.C. 1084, 1101 (1989), rev’d, 916 F.2d debt but to a change in foreign currency conversion rates. 110 (3d Cir. 1990): [I]t does not follow from...Commissioner v. However, the case has nearly always been discussed as if it Glenshaw Glass Co. that Kerbaugh-Empire is moribund for all involved forgiveness of debt. See Bittker et al., supra note 15. purposes. Nor does such moribundity flow from United States v. 26284 U.S. 1 (1931). Kirby Lumber Co.orCommissioner v. Tufts [citations omitted].’’ 92 27Bittker et al., supra note 15, at 4-20. T.C. at 1101.

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Zarin v. Commissioner,35 held that forgiveness of a gam- Returning to the numerical example above, if the bling debt owed to a casino did not generate income. mortgage loan is nonrecourse, on foreclosure the home- (C) Tax Analysts 2007. All rights reserved. does not claim copyright in any public domain or third party content. Although the court based its decision on the ground that owner is treated as selling the home for $94,000 (even the debt was not legally enforceable, the court also noted though the home’s value is only $90,000). Since the home that the taxpayer had gambling losses exceeding the cost $100,000, the homeowner has a $6,000 loss, which amount of the forgiven debt and referred respectfully to cannot be deducted because the home is considered the Kerbaugh-Empire ‘‘idea that ‘Courts need not apply personal consumption property. Nevertheless, the $4,000 mechanical standards which smother the reality of a excess of the mortgage liability over the home’s value — particular transaction’...hardlyanexceptional concept which constitutes a forgiveness of debt gain — is not in the tax realm [emphasis added].’’36 reported. This result is identical to what happens under the III. Other Considerations Kerbaugh-Empire principle. The $4,000 excess of the mort- There are additional considerations that favor apply- gage debt over the home’s value — in effect, the forgive- ing the Kerbaugh-Empire principle to the double-whammy ness of debt gain — does not produce income because it tax, involving the comparison with nonrecourse mort- is more than offset by the $10,000 loss in the home’s gages, the difficulty of subjective appraisals, the obstacles value. The transaction as a whole does not produce an to claiming the insolvency exception, and the prevalence overall gain, so the forgiveness of debt income is not of predatory lending in subprime mortgages. reported. Thus, nonrecourse home mortgages are treated under A. The Comparison With Nonrecourse Mortgages37 the regulations and section 7701(g) as if the Kerbaugh- When a mortgage loan is nonrecourse, the lender may Empire principle applied. Applying Kerbaugh-Empire to foreclose against the home securing the mortgage in the ordinary recourse mortgages would prevent any differ- case of default but has no recourse against the borrower ence in the treatment of recourse and nonrecourse mort- in his personal capacity, which is to say the borrower is gages. not personally liable. Thus, if the borrower defaults and B. The Need for Subjective Appraisals the mortgage debt exceeds the home’s value, the bor- If the excess of the unpaid mortgage over the home’s rower is not personally liable for the excess amount. value is income, then on foreclosure there must be an Because of the nonrecourse character of the loan, the appraisal of that value. Those appraisals are highly excess amount is in effect forgiven. subjective and often inaccurate, especially when home Although lenders virtually never agree to provide prices are in flux. Mortgage lenders that foreclose and do home mortgage loans on an explicit nonrecourse basis, not plan to sue the borrower for any deficiency have little some state statutes prohibit a mortgage lender from or no incentive to accurately value the home for purposes collecting any excess of the mortgage debt over the home of reporting the amount of debt forgiveness to the IRS.41 value on foreclosure.38 Those statutes have the effect of Moreover, when a bank reports an excessively low home converting ordinary home mortgages into nonrecourse value (and therefore an excessively high amount of loans. forgiveness of debt income), it may be extremely difficult Treasury regulations,39 in conjunction with a special for an ordinary taxpayer, especially one who is finan- code provision, section 7701(g), exempt nonrecourse cially distressed and cannot afford legal counsel, to loans from the usual rules governing forgiveness of debt. challenge the bank’s valuation.42 The excess of the mortgage debt over the home value is Applying Kerbaugh-Empire to foreclosure when mort- not counted as forgiveness of debt income. Instead, on gage debt exceeds the home’s value, however, would foreclosure, the homeowner is treated as selling the home eliminate the need to subjectively appraise the home’s for the full amount of the nonrecourse mortgage, even if value. The Kerbaugh-Empire principle simply asks the home’s value is less.40 whether the transaction as a whole generates an overall gain. This question can be answered by determining whether, on foreclosure, the unpaid mortgage exceeds the home’s basis (or cost). The principle can be imple- 35916 F.2d 110 (3d Cir. 1990). mented, in other words, by treating the home as sold for 36Id., at 116 n.11. the amount of the unpaid mortgage as is the case when 37 Contrary to this article, Prof. Deborah A. Geier would treat the mortgage is nonrecourse. both recourse and nonrecourse debt as producing foregiveness of debt income. See 1 Florida Tax Rev. 115 (1992). C. Obstacles to Claiming the Insolvency Exception 38 See, e.g., Cal. Civ. Proc. Code section 580b (prohibiting An additional argument for applying the Kerbaugh- deficiency judgments when a purchase money mortgage or Empire principle is that homeowners whose mortgage deed of trust is foreclosed, if the property is used as a dwelling debt exceeds the home’s value on foreclosure are often by the borrower). 39Reg. section 1.1001-2, Example 2. insolvent but either unaware of or incapable of claiming 40Section 7701(g) states: ‘‘in determining the amount of gain orloss...with respect to any property, the fair market value of such property shall be treated as being not less than the amount of any non-recourse indebtedness to which such property is 41Statements of Profs. Bryan Camp and Linda Galler, available subject.’’ If the mortgage debt exceeds the home’s basis, perhaps at http://taxprof.typepad.com/taxprof_blog/2007/08/ny-time due to debt financed by post acquisition appreciation, then s-doi-in.html; see also supra note 1. section 121 may wholly or partially exclude the gain. 42Id.

172 TAX NOTES, October 8, 2007 COMMENTARY / VIEWPOINTS the protection of the insolvency exception. As noted Exactly the same could be said of the failure to apply earlier, the code provides for not recognizing forgiveness Kerbaugh-Empire to the home mortgage cases. It produces (C) Tax Analysts 2007. All rights reserved. does not claim copyright in any public domain or third party content. of debt income if the taxpayer is insolvent, defined as an the incongruous result that the more a home falls in excess of liabilities over the fair market value of assets.43 value, the larger the increase in the defaulting, financially In practice, however, unsophisticated taxpayers who pressed homeowner’s income. are in fact insolvent may find it difficult to claim the protection of the insolvency exception. If they cannot afford legal counsel, they may be unaware of the insolvency exception. Even if aware of its existence, they may lack the expertise required to value their assets, particu- larly if subjective appraisals are required in the absence of readily observed market values. D. Predatory Lending in Subprime Mortgages A final argument for applying the Kerbaugh-Empire principle is that many homeowners whose mortgage debt exceeds the home’s value are victims of predatory lending. Such lending, defined as overpriced and excessively risky home loans, involving deceptive practices if not outright fraud, is especially frequent in the placement of subprime home mortgages.44 A typical predatory lending practice is to charge excessively high administrative and processing fees, which are added to the principal amount of the mortgage debt. If those fees have been obtained through deceit or fraud, their cancellation should not produce income under either the ‘‘disputed liability’’ or ‘‘fraud’’ excep- tions, which courts have recognized, to section 61(a)(12).45 As a practical matter, however, proving that a mortgage involving excessive fees was obtained through deceit or fraud may be beyond the capability of defaulting homeowners, who (as previously noted) are often unsophisticated and lack the resources to obtain expert help.

IV. A Final Thought In Zarin, the taxpayer borrowed nearly $3 million from a casino, which he lost gambling.46 Forgiveness of the gambling debt was said by the IRS to produce income under section 61(a)(12) even though the transaction as a whole produced no gain when the gambling losses were considered.47 Dissenting from the Tax Court majority’s decision favoring the IRS (a decision reversed by the Third Circuit), the eminent Tax Court Judge Theodore Tannenwald Jr. wrote that the IRS position ‘‘produces the incongruous result that the more a gambler loses....the larger the increase in his [income].’’48

43Section 108(d)(3). 44Kathleen C. Engel and Patricia A. McCoy, ‘‘A Tale of Three Markets: The Law and Economics of Predatory Lending,’’ 80 Tex L. Rev. 1255, 1259-1270 (2002); Lauren E. Willis, ‘‘Decision- making & the Limits of Disclosure: The Problem of Predatory Lending,’’ p. 2 n.5 (Loyola Law School (Los Angeles), Legal Studies Research Paper No. 2005-14, 2005), available at http:// ssrn.com/abstract=748286. 45See, e.g., N. Sobel, Inc. v. Commissioner, 40 B.T.A. 1263 (1939), Zarin v. Commissioner, 916 F.2d 110 (3d Cir. 1990), Preslar v. Commissioner, 167 F.3d 1323, 1331 (10th Cir. 1999). 4692 T.C. 1084 (1989), rev’d, 916 F.2d 110 (3d Cir. 1990). 47Id. 4892 T.C. at 1101.

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