The December 28th expiration of extended unemployment benefits, which cut off payments to 1.3 million recipients—and will cut off 3.6 million more over the next year—has dealt a painful body blow to the most vulnerable members of our society. Rolling back unemployment insurance to a maximum of 26 weeks when the average duration of unemployment is still 36 weeks puts millions of families’ lives in jeopardy.
Another recently expired provision could cause comparable damage to the same population, but it has yet to trigger similarly urgent attention from lawmakers. The end of the Mortgage Forgiveness Debt Relief Act, which lapsed December 31, means that any type of debt forgiveness on a mortgage will result in a giant tax bill—one that a stressed homeowner cannot usually afford. Even homeowners entitled to compensation for past abuse by the mortgage-lending industry would be subject to unfavorable tax treatment. This will lead to more economically debilitating foreclosures and weaken the housing market. Despite bipartisan support for an extension, it's anybody's guess whether Congress will get around to helping out struggling homeowners.
The Mortgage Forgiveness Debt Relief Act dates back to 2007. When the housing bubble collapsed, millions of homeowners fell into a Great Recession-induced crisis of lost wages and plummeting property values. Principal reductions—cuts to the unpaid balance of a home loan—have been proven time and again to be the most effective method for a homeowner to avoid foreclosure. But there was a problem: For tax purposes, the IRS treats forms of debt relief like principal reduction as gross income. So a $100,000 principal reduction for a family making $50,000 a year would force them to pay taxes as if they earned $150,000, saddling them with a federal tax bill (according to this calculator) of $32,493, or over two-thirds of their annual income. Struggling homeowners don’t typically have bags of cash lying around to pay off tax bills.
In 2007, Congress passed the Mortgage Forgiveness Debt Relief Act, exempting mortgage debt forgiveness from taxation. The law was extended twice as the foreclosure crisis lingered. It made it into the 2012 “fiscal cliff” deal at the last minute, extending relief through the end of 2013. But it expired last week, putting homeowners on the hook.
The need for mortgage relief is pressing. The most recent statistics show nearly 4.5 million homes are in some stage of delinquency. And more than 6 million homes are “underwater,” with the homeowner owing more than the home is worth. These homes are at risk of foreclosure, but many lower-income borrowers who can’t afford the tax bill will have to turn down mortgage help. Housing advocates were hopeful that the confirmation of Mel Watt to run the Federal Housing Finance Agency, the conservator for Fannie Mae and Freddie Mac, would lead to those agencies (which own or guarantee 90 percent of all new mortgages) finally offering principal reductions to prevent foreclosures. But the tax situation makes Watt’s confirmation irrelevant on this point.
The expiration of unemployment insurance exacerbates this problem, as long-term unemployed homeowners no longer have that lifeline. A federally funded program called the Hardest Hit Fund helps unemployed homeowners in 18 states with mortgage assistance. Each state program is different, but most involve some form of debt forgiveness. So unemployed homeowners get a double whammy: They lose their benefits at 26 weeks, and the program designed to help them keep their home while they seek work will encumber them with significant tax liability.
Perhaps worst of all, federal and state regulators recently secured two financial fraud settlements—with JPMorgan Chase and the mortgage servicer Ocwen—that required those firms to reduce mortgage principal by at least $3.5 billion. The principal reductions for tens of thousands of homeowners will now be taxable. So a benefit to homeowners—compensation for being abused by financial institutions—will end up actively harming them. In JPMorgan Chase’s case, the bank vowed to offer principal write-downs to hard-hit areas like Detroit. As if As if Detroiters didn’t have enough problems, now they must beware a bank bearing gifts that will penalize them.
Seemingly oblivious to the damage this will cause, federal officials have cited both the JPMorgan and Ocwen settlements as a template for future enforcement actions. “This has the effect of pulling people up with one hand, and hitting them in the face and knocking them over the cliff with the other,” said Senator Jeff Merkley recently.
The tax exemption also covered most short sales, in which banks agree to allow a property to sell for less than the value of their mortgage and forgive the balance. Short sales surged at the end of the year, as realtors strained to get them in before the tax break expired. We can now expect short sales to dramatically fall because it no longer makes economic sense for individuals trying to sell their underwater home to take on the big tax burden. This has implications for the entire housing market; it means reduced inventory for sale and fewer affordable homes available for buyers. And for those locked out of short sales or principal-reduction options, it means more foreclosures, which devastate communities and reduce property values.
There is a hardship exemption to the taxation of mortgage debt cancellation, but the individual has to prove that their total debts exceed the fair market value of their assets. This insolvency claim requires special reporting and documentation. Low- and moderate-income homeowners don’t necessarily have the tax-planning experience or resources to deal with this easily.
The good news is that there’s time for a deal. Tax bills for 2014 don't come due until next April. And there’s actually a potent coalition in place for this fight. Bipartisan bills in the House and Senate would extend the law for two more years. The House bill has 52 co-sponsors: 29 Democrats and an impressive 23 Republicans. Forty two state attorneys general from both parties (including conservative bastions like Idaho, Kansas, and Mississippi) have urged Congress for an extension, arguing that “this relief is crucial to both the homeowners struggling to regain their financial footing and to the battered housing market whose recovery is slow and still uncertain.” Because of the impact on housing, both consumer groups like the National Consumer Law Center and industry trade groups like the National Association of Realtors and the Mortgage Bankers Association support the extension as well.
The problem, congressional aides say, lies in finding a legislative vehicle for passage. Last year, the mortgage debt relief measure was lumped in with 55 other tax-related provisions known on Capitol Hill as “tax extenders.” Those expiring provisions did not pass last year, and aides doubt an extender bill could pass on its own in 2014, especially because of the fiscal cost and the need for offsets. The annual patch to the alternative minimum tax, which was previously used to pass such legislation, was fixed permanently in 2012, leaving less leverage for the remaining tax extenders. The imminent departure of Max Baucus, chair of the lead tax-writing committee in the Senate, who has been nominated to serve as ambassador to China, throws the issue into further disarray.
Aides argue that the tax extenders, and therefore mortgage-forgiveness debt relief, could get folded into the upcoming farm bill, or into legislation permanently fixing the payment rate for doctors serving Medicare and Medicaid patients. But with the budget off the table for two years, and few must-pass pieces of legislation on the horizon, the possibility exists for tax extenders to get orphaned despite bipartisan support.
If the effort falls flat, struggling homeowners will face the latest in a series of misfortunes, first from their lenders and now from the government. Homeowners are hurting, and they shouldn’t have to decide between foreclosure and a balloon payment to the IRS.