Subprime Phantom SlayerOctober 4, 2007 - by Donny Shaw
The bursting of the housing bubble and the the ensuing credit crunch is a financial crisis that affects all levels of the economy — although, to what extent is still unknown. One thing that is known, however, is that it is causing a lot of people to lose their homes.
Homeowners across the country are defaulting on their mortgages and lenders are foreclosing on homes at astounding rates. In some cases, lenders are offering to to accept less than the amount of debt that is owed to them based on the original agreement; otherwise, their thinking goes, they may never see any of it. But the government hasn’t been so quick to forgive. According to the tax code, this “debt relief” (aka phantom income; the drawing on the right describes this type of income) qualifies as regular income and is taxed accordingly.
The House of Representatives today overwhelmingly approved a bill, the Mortgage Forgiveness Debt Relief Act of 2007, that would make this debt relief tax exempt. Before getting into the details of the bill, let me offer a quick and rundown of how we arrived at the current foreclosure boom:
The whole thing began several years ago with the availability of long-term, low-interest mortgage rates. Potential home buyers, if their credit was good enough, were able to snatch up these competitively priced mortgages and buy expensive homes; they were suddenly able to afford the monthly payments. This increased demand and drove up house prices. As housing prices started to go up, subprime mortgage lenders began offering more loans with ridiculously-low, or interest only “teaser” rates. Again, more and more people were able to buy more and more expensive houses. The problem, though, was that the rates on subprime loans jump up very suddenly after a couple of years to a monthly payment level that most borrowers simply could not afford. This bubbling market then became further complicated by corruption. Both lenders and borrowers began deceiving each other, and subprime loans were given out with disregard. Virtually no attention was paid to the fact that, unless something changed, there was no way the loans would be payed off. The mortgage market was bloated with cheap money. When it finally burst, housing prices dropped suddenly. Many homeowners that had taken out subprime loans and had expected to be able to refinance their home when their rates went up, were stuck with a house worth drastically less than what they had paid for it and could not afford to refinance. And, as they also couldn’t afford the outrageously high payments of the mature subpime mortgage they were stuck with, they were forced to foreclose.
Many homeowners who have had to foreclose, it can be argued, are victims of an out-of-whack mortgage market. So, as Charlie Rangel (D-NY), the chairman of the House Ways and Means Committee and the bill’s sponsor, said, “families dealing with the pain of a foreclosure should not have the double-whammy of a large tax bill,”
The difference between what homeowners who have foreclosed owe based on their original agreement and the amount that they have renegotiated with their lender after foreclosure (or to avoid foreclosure) would be tax exempt under this bill. It would apply retroactively to debt forgiveness for all of 2007, and it would be limited to debts below $2 million. Some have argued that this cap is too high. “It has the effect of providing a new tax break for people with net worths in 7 figures,” said Joe Kristan of the Roth & Company, P.C. Tax Update Blog.
The loss in revenue that would result from relieving the tax on forgiven debt would be offset by changing the tax treatment of vacation and rental homes. The bill would alter a subtlety in the tax code that allows vacation and rental home owners to exclude $250,000 of capital gains from the sale of a home if they claim it as their primary residency for at least two years. Under the current bill, the capital gains exclusion would only apply to the percentage of time that they actually claimed the vacation home as their primary residence.
Besides addressing an issue of fairness, this bill seeks to repair the economy by plugging the pipeline of debt that has been initiated by the market collapse. “With the whirlwind of problems in the mortgage finance system,” writes Joseph M. Stanton of the National Association of Homebuilders, this bill “can help stabilize families, their neighborhoods, the surrounding community and the economy as a whole.”