Much written about the glaring lack of criminal prosecutions against leaders of the lending industry and the titans of Wall Street for their widespread fraud in the selling of mortgage-backed securities. This wildly lucrative collaboration created the historical financial crisis from which the world is still recovering. The feds have, however, brought some civil actions leading to large settlements. The most recent major litigation settlement in the news was between the Department of Justice and Bank of America (“BOA”). The lending giant agreed to a $16.7 billion payout to atone for its sins.
There is a component of this settlement of enormous significance to a great many borrowers. Justice and BOA agreed to earmark $490 million from the settlement for distressed borrower tax relief. Though not widely reported by the media considering its staggering widespread financial implications, this tax issue has adversely affected many borrowers and will continue to do so for quite some time unless Congress takes corrective action.
The back story to this tax issue stems from IRS regulations requiring that most forms of debt a creditor forgives (writes-off) for the benefit of a debtor is considered taxable income to the debtor. In the mortgage industry, especially through the foreclosure crisis, a lender will usually concede that it cannot recoup a portion of the outstanding debt. For example, a borrower may sell a property through a short sale with the lender collecting sale proceeds amounting to less than the mortgage debt owed.
This difference, known as the “deficiency,” is the amount the lender will write off by filing a 1099-C cancellation of debt form with the IRS. By doing so, the lender gets the benefit of claiming a loss on its books to offset other taxable income. In the view of the IRS, wherever there is a loss, there must be a gain. Accordingly, the lender’s loss as a taxable gain for the borrower. The IRS taxes the forgiven amount at the debtor’s ordinary income tax rate.
As the floodgates to the real estate collapse began to open in 2007, George W. Bush signed the Mortgage Debt Relief Act. This federal law modified the general tax regulation described above to allow borrowers, in most circumstances, to avoid being taxed for forgiven mortgage debt used to buy, build or improve their primary residence. The law has expired and been renewed, most recently in January 2013, retroactively to its sunset at the end of 2012. As we approach the end of 2014, the least productive Congress in our nation’s history has not voted to extend the law again, though there is a pending bill proposing to extend the tax relief into 2014. The bill’s sponsors seek to extend the mortgage relief through 2015 and estimate tax savings of approximately $5.4 billion.
It is difficult to overestimate the economic impact of such “phantom” income leading to large tax liabilities in an economy struggling to recover. When the real estate market crashed, property values plummeted, in many cases, to levels hundreds of thousands of dollars below the inflated appraised purchase or refinance value. This means borrowers receiving 1099 debt forgiveness will be taxed for the amount forgiven at their ordinary income tax rates for “income” they never received. When Warren Buffet said nobody ever went broke paying taxes, it’s doubtful he considered this scenario.
There are IRS legal provisions borrowers can pursue to offset or avoid this tax liability in some circumstances. These options should be discussed with a CPA experienced in real estate matters and include using the decline in value of the property, insolvency or bankruptcy to mitigate the tax damage.
The BOA settlement with the Justice Department provides some hope for relief but it will only cover a portion of the tax bill BOA’s borrowers are facing. A read between the lines of the settlement reveals a $25,000 cap on compensation that may be used to offset the tax liability. In states such as Florida, where it’s not unusual to see far more than $100,000 of mortgage debt forgiven following foreclosures or short sales, borrowers will be left scrambling to find Uncle Sam’s cash at tax time.
If Congress fails to pass an extension of the Mortgage Debt Relief Act in the lame duck session, the slowly-recovering economy is likely to suffer another setback from all the upside-down borrowers being burdened by a tax bill for income they never earned. Unfortunately, calls from the lending lobby are much more likely to get through to Congressional offices than their constituent borrowers’ pleas for relief.
