Posted by: mutantpoodle | August 21, 2007

Foreclosure double-whammy

20061218_foreclosure_2Yesterday’s New York Times ran a piece that describes the nightmare scenario for a family that loses its home: Foreclosure can be a taxable event.

Two years ago, William Stout lost his home in Allentown, Pa., to foreclosure when he could no longer make the payments on his $106,000 mortgage. Wells Fargo offered the two-bedroom house for sale on the courthouse steps. No bidders came forward. So Wells Fargo bought it for $1, county records show.

Agnes Mouser, a 65-year-old widow in Texas, received a $10,000 tax bill after foreclosure on her loan to pay off credit-card debt.
Despite the setback, Mr. Stout was relieved that his debt was wiped clean and he could make a new start. He married and moved in with his wife, Denise.

But on July 9, they received a bill from the Internal Revenue Service for $34,603 in back taxes. The letter explained that the debt canceled by Wells Fargo upon foreclosure was subject to income taxes, as well as penalties and late fees. The couple had a month to challenge the charges….

Foreclosure is one way that beleaguered homeowners can fall into this tax trap. The other is when homeowners are forced to sell their homes for less than the value of the mortgage. If the lender forgives that difference, they are liable for income taxes on that amount.

The 1099 shortfall, as it is called, stems from an Internal Revenue Service policy that treats forgiven debt of all types as income even if the taxpayer has nothing tangible to show for it, unless the debt is canceled through bankruptcy.

The Center for Responsible Lending expects that 20 percent of the home loans made in 2005 and 2006 to people with weak credit, commonly called subprime loans, will end in foreclosure. Because so little money was required as a down payment during the boom, the value of many of these houses may be less than what is owed.

Well, that’s nice.

The article points out that some people are fighting the IRS on this and winning. But really, this seems like badly written law.

The concept that a forgiven loan is income – when it was forgiven in exchange for consideration – seems screwy, and even if the consideration is less than the value of the loan, in the case of foreclosure, it doesn’t make sense to treat the event as a windfall.

Atrios has been suggesting that the Dems get in front of this mess. Of course, that was months ago, and the best they can hope for now is to catch up to the bumper and hang on for dear life. But attacking idiotic things like this – before the Republicans do it to shore of their “friend of the little guy” bona fides – seems like a good idea.

He also links to this piece by Dean Baker, suggesting that before foreclosure, there be an option for the borrower to rent the foreclosed house from the lender at an independently appraised (and adjustable, down the line) rate.

The advantage of this is that it doesn’t leave a family homeless or force them to pay to move somewhere else (disrupting work and school patterns). The devil is in the details, but it’s an interesting idea, and one that, as Baker points out, doesn’t

…immediately benefit the mortgage holders who speculated in predatory mortgage debt. For example, one popular proposal being circulated in Congress would vastly expand the role Fannie Mae and Freddie Mac, the government created mortgage intermediaries, in the mortgage market. This proposal would allow them to buy up hundreds of billions of dollars of subprime and other mortgages that the private sector does not want.

Of course, the private sector doesn’t want these non-prime mortgages because the default rate is soaring. If Fannie Mae and Freddie Mac suddenly got in the market for this debt, those who are currently speculating in these mortgages stand to make a fortune. It’s not clear that the government’s largesse will necessarily benefit moderate income homeowners facing foreclosure, but there is certainly a possibility that some of the windfall will trickle down.

The point here is simple. We can design a mechanism that will directly benefit millions of moderate income homeowners who are struggling to hang on to their homes. Or, we can come up with schemes that will benefit the banks and hedge funds who speculated in mortgage debt.

I’m guessing the banks and hedge funds will find relief before regular homeowners, but one can always hope.

Oh, and next time someone spouts off about the wisdom of the markets? This mess might be a good counter-argument.

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