Fix the Tax Code Friday: Mortgage Debt Cancellation

Fix the Tax Code Friday is back! This is your chance to sound off about tax policy – and propose how you would fix the Tax Code if you were in charge…

One of the heavily criticized pieces of the economic bailout package is the extension of the debt forgiveness exemptions for mortgage cancellations. Here’s how it works: traditionally, debt that is forgiven is taxable to the recipient as income to the extent of the forgiven debt. For example, if I owe the bank $1000 and I only pay $100 and the bank “forgives” the remainder, that $900 difference is taxable to me as income.

The idea behind treating forgiven debt as income is that not having to pay a debt that is owed is sort of like receiving a check for that amount. That $900 in the example above? It was a liability on my balance sheet which would have been paid off with income (or other assets). Moving it to “zero” has to be accounted for somehow; the answer, for tax and accounting purposes is to treat the forgiven debt as if I had received a check when the debt was wiped clean.

That was the traditional rule. However, to counter the growing numbers of house foreclosures and subsequent tax problems which resulted, Congress has exempted certain debt forgiveness as a result of mortgage cancellations from inclusion in income. This has relieved some taxpayers, who felt that the tax provisions punished them twice, and angered others, who question why former homeowners are getting a break for making what was perceived to be a poor decision in the first place. Other taxpayers also question why the exemption didn’t extend to other personal debt, like credit cards and personal loans, that were forgiven as a result of nonpayment.

So today’s Fix the Tax Code Friday question is a two-parter:

Should Congress have allowed taxpayers whose mortgage debt was forgiven to exempt that debt from income? And, should Congress have taken it a step further and exempted all forgiven debt including credit cards and personal loans from income?

Tell me what you think!

Comments

  1. Colin

    They shouldn’t be meddling in the markets at all. And they certainly shouldn’t be rewarding careless homebuyers by giving them a tax break. Where’s my tax break for buying a crappy little row home I could afford?

  2. Bryce

    I find it interesting that the justification for a good deal of tax policy is related to assessing the tax when the cash is paid or received, yet these cases ignore that principle entirely.

    On principle, I don’t think debt forgiveness should count as income. As a practical matter, if debt forgiveness doesn’t count as income, then it’s too easy to use it to hide income, claiming the debts were forgiven instead of paid off. So I’m stuck wishing people were honest enough for the ideal system to work.

  3. Melody

    This is a tough one. Those of us who are fortunate (or perhaps unfortunate) enough to itemize do get a reduction in income for home mortage or equity line of credit interest. But, if you lose that asset, you’ve lost the deduction. You have to figure that those people who have had their debt forgiven have likely lost the asset after a long fight with the bank. If they didn’t have enough income to pay the mortgage, then they very likely don’t have it to pay the resultant taxes. Perhaps a one-time forgiveness of taxes might be a way out. In other words, if you do it twice, maybe your next house should be the IRS auditor’s office.

    When it comes to credit cards and personal loans, the interest on those have not been used as a deduction for years. If they’re not tax-deductable, why should anyone be forced to pay tax on that forgiven income? Banks should be handling that by refusing to extend credit to those who defaulted for a LONG time.

    Now, I’ve not been in a position (knock on wood!) where I have had to re-negotiate a debt, so perhaps this is a little simplistic. If so, go ahead and blast me.

    Melody

  4. Suz

    I have to echo Colin’s remarks. In many ways I feel as though the fact that I purchased a home within my means and paid a reasonable interest rate on a traditional 30 year mortgage is being overlooked. I am not getting any ‘windfall’ by in essence the government giving me a wind fall of income by re-valuing my house. Maybe I should have bought a McMansion in the suburbs that I couldn’t afford.

  5. Sandy Phillips

    There was a day when having your home foreclosed upon by the bank was shameful. Along with the social consequences, there were financial ramifications, such as a tax bill owed to the government. Now, both situations are in the past and we are not a better country for it. Signing your name on a contract should mean something. Whatever happened to personal responsibility?

  6. Another Tax Geek, CPA

    This is easy. Policy wise, there is absolutely no way that forgiven debt should not be income. To reward those who’ve made poor decisions, and in effect, have the rest of us pick up the tab is a slap in the face to everyone who lived at less then a fully leveraged ‘keep up with the jones’ lifestyle and actually pays their bills. I do think a deferral of some sort might be a reasonable solution, something that doesn’t let them escape the tax, but results in it being paid back over either future years or upon sale of the house. With interest of course, the rest of the taxpayers have gotten screwed enough already.

    Taxwise, there’s a general concept that a deduction to one party is income to another (barring nondeductible personal expenses, etc.), so how could it possibly make sense to allow a bad deduction to the makers of these loans, while exempting the debt relief the deadbeats received?

    What I want to know is where’s the bailout for those who’ve paid their bills and acted like responsible grownups? Makes me wonder how long until Atlas starts shrugging.

  7. bill

    Okay, I have to vent; and I’m sure I’m not the only one who feels this way. So this is for all of us. With a large piece of my professional career behind me, I look back at the long hours and the sacrifices I’ve made to play by the rules and do what is right. I’ve faithfully paid my bills and taxes, only to have my hard earned retirement dwindle with a couple of “market corrections.” Now as consolation for my diligence, I get to watch while others get out of debt Scott-free without even paying the tax on it. Wow, do I ever feel foolish! Maybe its time I stop this nonsense and figure out how to get on this gravy-train before it pulls out of Bailout City. I’ve had enough. Anyone have any pointers on how I can suspend my conscience and short circuit my way to Easy Street? If they can do it, why can’t I?.

  8. Author
    Kelly

    I have to agree which much of what is said.

    We have watched as folks bought more house than they could afford – some of them seven to ten times more than we paid. We know people that bought three or more vehicles just because they thought they could. We watched as people re-fied and re-fied to buy new furniture and expensive accessories. And we watched as those people chose to default on credit card and other bills after the fact with virtually no consequences.

    Now, many folks are screaming that they need help.

    And some of those folks are legitimately in bad situations because of the market and joblessness.

    But some of those folks have dug themselves into a hole because of their own greed and carelessness.

    It’s tough because I want to be compassionate. I understand what it’s like to struggle. But I also know that my husband and I made tough choices in order to get by – like driving a car that had 189,000 miles on it when we got it instead of buying a new car that we knew we couldn’t afford. And somehow, bailing out someone who has chosen to overspend is just distasteful to me.

    Chris often asks me what we will tell our children about these things. I hope that we can tell them to live honestly and do the right thing. Sadly, the examples out there are few and far between.

  9. Melody

    Kelly,

    I have to agree with you. My mother was a child during the Great Depression, but she remembered with real fear the hushed conversations between her parents after they thought she was asleep. I think that due to that experience, she drummed into my head from a very early age that I should be proud of what I could afford and just work hard to get what I wanted. Buying it and worrying about how to pay for it later has never been an option in my life. I think my generation has at least been a little uneven in imparting that to our children. We’re living with the consequences. I’m not saying that this is all our fault, but I think we could have done a better job.

  10. David

    WOW, a lot of angry people out there.
    The tax question (in my honest opinion) is simple. If I have a mortgage debt of say $100,000 that I walk away on because I can’t pay it for whatever reason, then how would I be able to pay $28,000 in taxes on it as income and I still have no place to live? PLUS, in the mean time I pay the “income” tax on this while the business takes a “write off”, gets a bail out from the feds, and then can turn around and sell the house and make a profit while depreciating it’s value as an asset the whole time. What the heck? So many people have had the house stolen out from under them, and others deserve what they get.
    Answer: VALUES. What is the “real” value of the home? That is the part of the loan that is not “forgiven” but rather transfered back to the bank. It was the bank that said okay to this loan, and so they now own the house. The borrower owes a penalty tax on the part of the loan that was forgiven and NOT on the transfer of the value to the bank. It seems a little more balanced responsibility to both parties. No one gets off scott free. If the government has to step in and buy the value of the home then it’s US that get the bill for it. WHY? I get that people are angry for having to pay for the “free lifestyle” of their neighbors and I am too. But I am also angry that many of the most wealthy are walking away from this making tons of money from it. I read somewhere (don’t know if it’s true) that the top 400 people in the nation have more wealth than the next 150 Million combined! AND it was estimated that they have profited 700 Billion dollars in the last eight years off this mess. Is it just me, or have I heard that number somewhere before? How did they arrive at that number so quickly, when they still don’t know the value of the houses or the paper that wall street and the banks are holding? You tell me how. And in the mean time it’s the seniors that got screwed the worst. Mny lost the home they have lived in forever. They have no way of increasing their income much, and if they do too much, they loose HALF of their SSI. Balance. That’s what we need. Balance.

  11. eadn

    I came into some money last year (2007) and paid off my mortgage to the tune of $85,000 and change. Personally, this tax-free cancellation of mortgage debt for bad borrowings/lendings makes me want my money back AND tax-free too!
    Think I’ll ever see it? Not a chance!

  12. David

    I just realized that I have even more to say on this. For those of you that believe that there should be an income tax on forgiven debt…

    Think about it this way. If I borrow money and not pay it back, then I have increased my position, right? But, if I borrow money to buy a house and I don’t pay it back, they take my house. Why would I have to pay income tax on something I don’t even have? I suppose if I get to keep the house and have to pay taxes on the “forgiven debt” well then I would understand it because it is something I have and my position has increased. But, take my house, AND tax me on the loan amount as if were income, now you’re talking about taxing the income I get from my job and taxing me on income I never got, while the banker doesn’t have to pay any income tax on taking over the property. Do you people even hear yourselves? Would you like that kind of a deal? I tell you what, imagine right now if the IRS walked in and said you didn’t pay your taxes on the first month you bought your house, so, we are taking the house, car, boat, and anything else you have a loan on, but, the good news is your debt is forgiven, however, you will have to pay income taxes on the forgiven amount. Oh, and by the way… I think there is a shelter around the corner and if you hurry you might just make it there before they are full for the night since you no longer have a house.

    As much as I dont encourage the thought of that jerk next door with three cars and the new deck and grill getting off the hook and me picking up the tab, I just couldn’t live with my self knowing that someone put my mother (God rest her soul) out on the street took her house and then told her to pay income taxes on the amount of the loan that she hadn’t paid yet all because some fast talking guy convinced her that it would be better for her to use a home equity loan than to use her credit card because the intrest was lower.

  13. Norma

    It is a hard question,but there is always someone worse. A mortgage re- finance was done on our house for 80,000 of which almost 3500 was to come to us. The 3500 was a bounced check of which the title company has since gone bankrupt the mortgage broker, of course, broke it to another company and also has filed bankruptcy. So here I am with messed up mortgage papers They took my name off the house (by mistake) my husband has since died, and I am on a disability. I am making my mortgage. We also had started a bankruptcy case,which I am making the payments on. I have been know to cry a lot because this is a mess, but wait there is a
    bright side, someone may be worse off. Tax break where I don’t even get to claim interest on my house, my income is too low. Have a good one

  14. Pingback: Foreclosures, Debt Forgiveness and Mortgage Losses Explained | taxgirl

  15. Another Tax Geek, CPA

    David,

    I was going to respond to your comments, but there are too many errors in your posting to be worth my while. Suffice to say, you should learn how debt forgiveness is taxed before commenting on whether it’s correct. Check http://www.irs.gov for a primer.

    And by the way – yes, the entity that made the loan gets a deduction for the bad debt, but recoveries are brought back into income, and foreclosed houses don’t sell for much. The net deduction realized by an entity over the course of these transactions (loan/foreclosure/bad debt/recovery) is equal to the actual cash lost. The bailout is a different matter, but if done right (I know, I know, we’re talking about politicians, so the odds of that are slim) the taxpayers should earn a return on this.

  16. Richard K. Dirham

    SURE!! Let people who borrowed more than they could afford off the hook!! Continue to punish those of us who have made our paymants over the years and not lived from payday to payday. We’ve had to pay tax on the interest from our savings for years. Why should those who did not save a thing, spent all they earned and all they could borrow have to face reality?? Yup, Congress should lend a helping hand to those folks. While there at it, Congress should give itself a raise and praise itself for saving the ecomomy. An Ohio Saver!!

  17. Chris

    Government interference always benefits bad decision making.

    Welfare, medicaid, and the mortgage bailout all benefit those that made poor decisions in life. Wall Street made all kinds of bad decisions and look how the government is bailing them out.

    The key is to make the same bad decisions as many others. If the government sees too many people suffering from the same bad decisions, they will step in. If you make a poor decision at a bad time (like when there is no growing crisis) you will most certainly be left out. I.E. if you bought a house in a flood plain and a flood knocked out your house, w/ no insurance you are SOL. If thousands of people did the same thing at the same time, the government will step in and bail everybody out.

    If you made all good decisions, good for you, you get no direct benefit, only tax bills.

  18. Author
    Kelly

    Robert –
    Your comment got caught in my spam filter (ironic what it won’t catch). Thanks for the link!

  19. Pingback: Fix the Tax Code Friday: Mortgage Debt Cancellation | taxgirl

  20. Jules

    Whoa! Lot of self-satisfied posters on this thread. Can you spell “schadenfreude”?

  21. wajansen

    I think we won’t have to worry about any of this within a few years. I feel the economic system as we know it now, won’t even exist.
    WA

  22. Ann

    Perhaps at this point the postings have seen more of a reality as to what is really happening from the home bubble implosion.
    I’ve worked in Mortgages for about twenty years. I’ve worked on the front lines and behind the big doors that bartered the sale of bulks of loan.
    A. The government didn’t cause this issue.
    B. Greed from primarily traders selling sub-prime loans on the secondary market were almost entirely to blame for the feeding frenzy.
    –When you buy a house the first couple of payments are made to a lender who almost always sells a big bulk of loans to the secondary market. Imagine cattle auctions. Selling at par pricing would be 100, selling for a 1% profit would be 101. Sub-prime loans were selling at 106. There wouldn’t have been enough air in the bubble to burst if not for the feeding frenzy this started.

    C. The government bail out – you probably all know by now who got the money (the same guys from B)
    D. While there are plenty of people who bought within their means, they still ended up buying an over-valued property if they bought between 2003-2008…. Once again, say a big Thank you to the guys referenced in B.

    To complicate it all, the lenders (holders of mortgages) have NO motivation to lower your principle (which the bail-out should have gone towards). They get tax write-offs from the government (incentive to foreclose). In many cases these people would buy the same house at 5-15% over current market value BUT NO, the securitized holders of the notes foreclose and sell the property at (typically) 20% UNDER market value.

    The government should have given everyone with a mortgage which was taken out between 203-2008 a sliding scale check in the name of the Lender to pay down their mortgage. They also should have required the Note holders to re-cast the loan payments in leu of the principle pay down.

    Without removing the loophole (i.e. tax write off incentive to foreclose), we are going to be doomed for a very very long time.

    Almost all the people who received loan modifications have done so with the higher jacked up principle. Most of these people will need to sell their property or refinance within the next fifteen years. When that time comes, via a divorce, death, job transfer and the like… they are still underwater on their mortgage and will most likely hand the keys back to the greedy note holders.

    Remember who was bailed out, it wasn’t the people.

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