Looming tax peril for underwater homeowners

David Dayen has a story at Salon that is genuinely must-read. He’s flagging the fact that for the last three years, there has been a federal law which excludes principal reductions from homeowners from taxation. Any amount of debt that is written off by banks during a mortgage modification has not been counted as taxable income. That law will expire at the end of 2012, making it likely that homeowners who receive principal reductions, sell their homes at short sale, or received compensation as part of the national mortgage settlement or Servicemember Civil Relief Act settlements will have to pay federal taxes on the money. Given that these are almost entirely people who are in foreclosure due to a lack of money, this could be devastating.

Imagine struggling near foreclosure in an underwater home – you bought it for $300,000 but now it’s only worth $200,000. You get your bank to make a deal to keep you in your home, cutting the principal on your mortgage by $100,000. Great! Only if this law expires and the mortgage modification happens after its expiration, you’ll now be sent a federal tax bill that could be $20-30,000 or more, depending on your income. It’d be crushing.

If this tax policy isn’t dealt with and comes into existence next year, it would be as functionally stupid as any which exists in America today.

What’s terrifying is that extending this law would be a tax cut at a time when Washington is captured by deficit fever. Per Dayen, “the Congressional Budget Office estimates that excluding principal reductions from taxation for two more years will save recipients $2.7 billion.” $2.7 billion isn’t a ton of money, but it isn’t nothing either. Since we’re facing a fiscal cliff, plus the expiration of the Bush tax cuts, plus the debt ceiling, it’s clear that Congress will be looking for ways to save money, particularly from powerless constituencies. And given the lack of action by Congress to aid homeowners, it’s hard to imagine a less powerful constituency than homeowners at risk of foreclosure.

Nonetheless, there are multiple pieces of legislation moving through the House and Senate aimed to extend the protection for homeowners. Keep in mind that the initial law was set to expire after three years because it was assumed the housing crisis we were in would be over by then. Obviously that assumption was wildly optimistic. We need a fix that will survive on a long enough term to actually right the housing market. Dayen again:

At stake is the future of the housing market itself. Though analysts keep touting a bottoming out of prices and home sales, the numbers suggest that there’s still a long way to go, and the biggest stumbling block remains negative equity. “For us to get to a housing recovery, we really do need significant principal reduction,” said Rheingold. “As we’re seeing the first signs of doing any principal reduction or short sales, if this tax relief is allowed to expire, it would really do tremendous damage.”

Senator Debbie Stabenow and Rep. Jim McDermott have both introduced bills to fix this. Stabenow’s is just a one year extension, though McDermott’s is quite comprehensive. It’s easy to imagine dealing with this issue becoming a yearly task for Congress, as no one wants to do anything that can be seen as contributing to the debt long term. As a result, homeowners at risk of foreclosure may remain in an even more precarious position for a long time to come. This is the real sort of uncertainty which hurts people and the economy (as opposed to the fictional uncertainty which fuels invisible bond vigilantes).

This issue has largely flown under the radar to this point in time. Hopefully Dayen’s reporting, as well as work being done by activist groups like ACCE, will put pressure on Congress to act quickly. The longer this goes unresolved, the more likely it will be lost in the coming hysteria around expiration of the Bush tax cuts, sequestration, and the debt ceiling.

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