“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 [October 4, 2007 – Ed.] as the House approved legislation to help financially strapped homeowners.

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

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“I never said half the things I said.”

Not only has the President’s Advisory Panel on Tax Reform thought about the unthinkable — repealing the mortgage interest deduction — it has actually advanced two distinct proposals for comprehensively overhauling the tax code.  While some may see this as nothing more than a trial balloon, I think it will be floating in political possibility space for most of 2006.

The Panel’s major impetus behind the proposals (for a full description see Recap Advisors’ summary, link in .pdf) is, ironically, to undo a provision enacted in 1969 as an anti-embarrassment measure but one that now bids to engulf the rest of the tax code: the Alternative Minimum Tax (AMT).  Because the AMT is not indexed for inflation, over time it captures more and more taxpayers.  Today it affects more than three million households, and current projections show that by 2010, it could affect thirty million households: 90% of households making more than $100,000 per year, and one-third of households making $50,000 to $100,000.  Repealing it is expensive, costing a trillion dollars — that’s $1,000,000,000,000 — over ten years.

“One trillion dollars!  Right …”

Paying for this AMT repeal is hideously expensive, so the Panel, in an exercise of classic old-school political jiu-jitsu,

Please justify your program’s tax expenditure

reverses the burden of proof.  As Recap’s Web Update (to subscribe, click here) puts it:

The Panel achieves this goal by starting from a presumption that nearly all tax preferences should be eliminated.  At a stroke, this captures an enormous amount of income which can ‘pay for’ repealing the AMT.  In addition, zero-basing all current preferences in effect makes all current tax incentives politically guilty until proven innocent.

Naturally, wiping out all current preference beneficiaries means that they will instantly unite to condemn the proposals, and the knee-jerk hyperbole has already begun.  However, in politics, perception is reality, and threats are reality until they are extinguished.  Moreover, a proposed law costs no political capital, making the threat of a proposed law politically stronger than its execution:

Aron Nimzovich: “the threat is stronger than its execution”

About the only certainty is that the uncertainty is likely to persist well into 2006.  That’s bad news, because threats can depress market, even if they have minimal chance of passage.

But then I started thinking about the timing.  Politically astute operators start from the end game and work backwards.  Because the public’s moods are fickle and memories are short, timing is all.  The launch of these proposals has been deliberately timed for a period when:

• Congress is out of session.
• The 109th Congress’s first session (odd year) is over, and the second session (even year) will not begin for a couple of months. 
• The second session is always an election year.

So this proposal has been carefully dropped into a place where it cannot be voted down, indeed cannot be given due consideration, so it will seep into the public consciousness.  What is the proposal’s most significant effect?  To remove several million taxpayers from an obnoxious and reviled tax on middle-income Americans. 

Somebody is playing very deep positional political chess indeed.

In chess a player often speaks of a position “playing itself” because the natural moves are effective.  In political chess this proposal plays itself because the natural sound bites work:

• “Cutting taxes for middle-income Americans.”
• “Simplifying the tax code.”
• “Eliminating fat-cat tax breaks.”

Who could be against that?

“Who’re you calling a fat cat?”

If I sound cynical, it’s because these shibboleths are the same ones deployed in 1986 and 1969 when the tax code was most recently overhauled.  The irony is that the AMT — what we now wish to eradicate — was created in 1969 as a massive tax reform invention to make sure everybody paid some tax, and today it bids to assure that millions pay too much tax.

Speaking of 1986, I can’t help recalling the Panglossian denial with which I and my colleagues back then viewed the emergence of what became the Tax Reform Act of 1986.

“All is for the best in this the best of all possible tax codes.”

Right up until the decisive moment – the public announcements following the closed-door House-Senate conference – the ‘smart money’ thought reform would never happen, and if it did investors would certainly be grandfathered.  Wrong, and wrong, and painfully wrong. 

And my friend Fred Copeman, whose experience extends even further back than mine, offers this memory:

It reminds me of my attendance at the “Stanger Forum” late in 1985.  Bob Stanger hosted that meeting once a year, as you may recall, a gathering of all the chieftains of the tax shelter industry – $5k per head, black tie, cigars and brandy – the whole thing.  I remember running over to Filene’s Basement to buy a tux.

The evening felt like a throwback to a 19th century dinner meeting of railroad tycoons talking about price fixing, Congress-buying and all of that fun stuff.  The after-dinner speaker was Barber Conable, a Republican Congressman from upstate New York [Later president of the World Bank! -- Ed.] and at the time the Ranking Member of the House Ways and Means Committee.  At the time there were some serious rumblings about tax reform but Mr. Conable, in a particularly expansive moment, said something like the following:

“Boys – you have no need to worry about all this talk – we don’t ‘do’ radical tax reform in this country.”

The rest, as they say, is history.

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