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

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Mortgage Double Whammy: First, Ever, Suffers from Two Serious Defects (C) Tax Analysts 2007. All rights reserved. does not claim copyright in any public domain or third party content. 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.
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