Relief from relief
“Restructuring my loan — it was horrible, Xena!”
With all the travails of delinquent borrowers in the subprime mess, you’d think that losing one’s home to foreclosure would be the only financial bullet one might have to dodge —
Glad I avoided foreclosure
— and that, if by some good fortune the borrower was able to modify the loan, all would be well.
“All is well! All is well, God damn it!”
Unfortunately for borrowers, under current law there’s a further penalty to avoid – that is, unless the Senate enacts a piece of tax legislation paralleling a bill the House passed a month ago. As reported in the Washington Post;
Financial relief for homeowners facing foreclosure or in bankruptcy advanced yesterday [
The bill, passed on a 386-to-27 vote, would give a tax break to homeowners who have mortgage debt forgiven as part of a foreclosure or a reworking of a loan. The value of that forgiveness, which is now taxable as income, would become tax-exempt.
Counterintuitive as it may seem – who gets charged with income for losing her house? – actually makes sense in an accounting context, because of the tax code called Cancellation of Debt Income (CODI). As Wikipedia puts it reasonably well:
The standard definition of income is found in a United States Supreme Court case entitled Commissioner v. Glenshaw Glass Co.[2] The Court defined income as 1) accession to wealth; 2) that is clearly realized; and 3) over which the taxpayer has complete dominion.[3]
Prior to this decision, the Court had already determined that the cancellation of debt was “a freeing of assets.”[4] Basically, when debt is cancelled, money that would have been used to pay that debt is now free to be used on anything else the taxpayer wants. This is also known as “accession to wealth.” Therefore, under Glenshaw Glass, it seems only natural to include COD income in gross income.
Let’s take a simple example. I borrow $100 from you. This transaction does not make me any richer, because though I now have $100 in my pocket, you hold my IOU.
My assets and my liabilities have each increased by $100, so my net worth is unchanged.
As long as assets balance liabilities, no income, no net worth
Now, suppose that, for whatever reason, you decide to tear up my $100 IOU and substitute an $80 IOU in its place.
Just swap one for the other
That makes you a good Samaritan, doesn’t it? Or perhaps merely a sensible loan asset manager.
What does it mean for me?
Even though no cash has changed hands, I am now $20 richer ($100 - $80) because now I owe you less money.
As the debts go down, net worth goes up
In tax terms, I have enjoyed Cancellation of Debt, and that is income — ordinary income.
Income, ordinary income
While this may seem unfair initially, if you think about it, the home owner has preserved her asset — the home — and had her liabilities reduced. Good for her, probably good for the neighborhood, but not fundamentally different from being given a $20 bill and then sending it to the lender to pay down the loan. It’s income.
The House legislation, HR 3648 solving this problem not by exempting the income from tax (the Post’s summary is technically inaccurate), but rather by allowing the taxpayer to reduce her basis in the home. That is, the house — which the taxpayer listed as having been worth $100 — will now carry a ‘book value’ to the taxpayer of $80.
This will make no difference while the taxpayer lives in the house, but if she sells, she’ll have $20 more gain than she otherwise would. At worst she’ll pay tax many years in the future — and in fact, under current tax law, many sellers of principal residences get an exemption from capital gains on sale, so she may never pay the tax.)
So this is a nice thing — which is why it so overwhelmingly passed the House.
But there’s a fly in the ointment.
Problem in there somewhere
Compared with current law, enacting this change will cost money — what the budgeteers call ‘tax expenditure’:
While the measure is anticipated to reduce the taxes of some strapped homeowners by $650 million —
It’s gonna cost $650 million to get you out of there
— it also looks to help offset that by limiting a tax break available on the sale of second homes.
Even as these subprime borrower home owners get a savings, it is ‘paid for’ by increasing taxes on a different group of homeowners — those who have a second home, and sell it.
This arises because Congress is operating under a budgetary rule known as Pay As You Go (PAYGO), whereby each new measure has to be ‘revenue neutral,’ meaning that whatever Congress spends in one part of the tax code, it must recoup from another. Since that makes virtually every manner of tax reform an explicit wealth transfer from one group to another, it’s unsurprising that this measure isn’t a shoo-in:
The White House supports the tax measure but wants the mortgage relief to be in effect for three years, not permanently, as approved in the House. President Bush is opposed to limiting tax breaks on the sale of second homes.
Much though I would like to deride the White House’s view, it’s reasonable in this context. The sunset date is logical.
There goes my tax break
The relief is being granted due to a perceived emergency circumstance of first-time over-extended borrowers whose mass failure could damage housing markets nationwide; it makes sense to put a time limit on the provision, as it can always be made permanent later.
“Families dealing with the pain of a foreclosure should not have the double whammy of a large tax bill,” Rep. Charles B. Rangel (D-N.Y.), chairman of the House Ways and Means Committee, said of the tax-relief measure he sponsored, H.R. 3648.
Actually, Mr. Rangel’s legislation makes no difference to people who are foreclosed, since they lose the house and pay the same tax in any event. The relief is provided to those who restructure their loans and keep their homes.
It’s the thought that counts
Write a comment