Short sellers’ fiscal cliff

The Bush tax cuts aren’t the only measures that expire on New Year’s Day.  So will the Mortgage Forgiveness Debt Relief Act of 2007.  Without that law, homeowners who have negotiated a short sale–that is, have part of their mortgages forgiven by the lender because they are so far underwater when they sell their home–will have to count the amount chopped off their mortgage as income for tax purposes.

Say a person owes $200,000 on his house but it’s only worth in today’s market for $100,000.  If the mortgage is held by the federally regulated lender Fannie Mae or Freddie Mac, there is a federal program that makes it possible for the underwater amount to be forgiven when the home is sold at market value.  So in a short sale, the person might be able to sell the home for $100,000 but be clear of the mortgage.  But after New Year’s Day, he will have to declare the $100,000 that Fannie Mae wrote off as if it were money that he actually received.  And then pay taxes on it!

Various bipartisan bills have been proposed to extend the Mortgage Forgiveness Debt Relief Act, but no votes are scheduled, and it isn’t part of the package that either side is proposing in the fiscal cliff negotiations.

 

via Short sellers may be hit with big income tax bills if Washington doesn’t act – The Washington Post.

About Gene Veith

Professor of Literature at Patrick Henry College, the Director of the Cranach Institute at Concordia Theological Seminary, a columnist for World Magazine and TableTalk, and the author of 18 books on different facets of Christianity & Culture.

  • SAL

    I hope theMortgage Forgiveness Debt Relief Act is renewed. It’s probably had a more positive effect on people’s lives than any other piece of legislation in the past 6 years.

    However it raises the question where does the IRS get off treating forgiven debt as income for things besides homes?

    Can’t we raise taxes from other means besides persecuting familes that are worse than broke?

  • SAL

    I hope theMortgage Forgiveness Debt Relief Act is renewed. It’s probably had a more positive effect on people’s lives than any other piece of legislation in the past 6 years.

    However it raises the question where does the IRS get off treating forgiven debt as income for things besides homes?

    Can’t we raise taxes from other means besides persecuting familes that are worse than broke?

  • Patrick kyle

    However it raises the question where does the IRS get off treating forgiven debt as income for things besides homes?

    And a good question it is.

  • Patrick kyle

    However it raises the question where does the IRS get off treating forgiven debt as income for things besides homes?

    And a good question it is.

  • Dr. Luther in the 21st Century

    This has always struck me as a rather dumb tax rule.

  • Dr. Luther in the 21st Century

    This has always struck me as a rather dumb tax rule.

  • Joe

    The home owner will still be in a much better position that having $100,000 debt on a home he no longer owns, which is where he would be without the program.

  • Joe

    The home owner will still be in a much better position that having $100,000 debt on a home he no longer owns, which is where he would be without the program.

  • SAL

    Someone who can’t afford $100,000 of mortgage debt probably can’t afford a $25,000 bill from the IRS (to be paid all at once at year end).

  • SAL

    Someone who can’t afford $100,000 of mortgage debt probably can’t afford a $25,000 bill from the IRS (to be paid all at once at year end).

  • DonS

    The problem with treating forgiven debt as income is that this treatment is not reciprocal. In theory, if you borrowed $100,000 on your credit cards, received the stuff you paid for with that $100,000, then defaulted on the cards, you received $100,000 in tax-free income. Someone who used saved wages to pay for their $100,000 had to pay taxes on those wages, while you paid no taxes on the $100,000 “loan” you failed to repay. So, I don’t have a problem with treating forgiven loans as debt. However, the problem is that taxpayers who suffer capital losses are very limited in being able to claim those losses. That is what I mean by reciprocity. If you suffer a $100,000 loss because someone didn’t pay your loan back, that should be directly deductible against current income. It’s not, however. Similarly, if you suffer loss on your house value which causes you to have to short sell that house, any income that is imputed to you because of the short sale should be offset directly by the capital loss on your home. And, beyond, if the loss was greater than your gain from the short sale.

    This is one area where the tax man really stabs us in the back, when we’re down.

  • DonS

    The problem with treating forgiven debt as income is that this treatment is not reciprocal. In theory, if you borrowed $100,000 on your credit cards, received the stuff you paid for with that $100,000, then defaulted on the cards, you received $100,000 in tax-free income. Someone who used saved wages to pay for their $100,000 had to pay taxes on those wages, while you paid no taxes on the $100,000 “loan” you failed to repay. So, I don’t have a problem with treating forgiven loans as debt. However, the problem is that taxpayers who suffer capital losses are very limited in being able to claim those losses. That is what I mean by reciprocity. If you suffer a $100,000 loss because someone didn’t pay your loan back, that should be directly deductible against current income. It’s not, however. Similarly, if you suffer loss on your house value which causes you to have to short sell that house, any income that is imputed to you because of the short sale should be offset directly by the capital loss on your home. And, beyond, if the loss was greater than your gain from the short sale.

    This is one area where the tax man really stabs us in the back, when we’re down.

  • dan kempin

    Come on, everyone. Forgiven debt IS income. I don’t oppose the legislation, and I do have fundamental problems with the IRS and the concept of income tax, but let’s be consistent: The bank lends a person $200,000, and the person only pays back $100,000. That is a gift of $100,000. Never mind that they don’t have it any more, it is still income. They borrowed it and lost it in a bad investment. Otherwise anyone could circumvent taxes on a large gift by simply lending the money and then forgiving the debt.

  • dan kempin

    Come on, everyone. Forgiven debt IS income. I don’t oppose the legislation, and I do have fundamental problems with the IRS and the concept of income tax, but let’s be consistent: The bank lends a person $200,000, and the person only pays back $100,000. That is a gift of $100,000. Never mind that they don’t have it any more, it is still income. They borrowed it and lost it in a bad investment. Otherwise anyone could circumvent taxes on a large gift by simply lending the money and then forgiving the debt.

  • DonS

    Oops. The sentence ” So, I don’t have a problem with treating forgiven loans as debt.” in my comment @ 6 should read ” So, I don’t have a problem with treating forgiven loans as income.”

  • DonS

    Oops. The sentence ” So, I don’t have a problem with treating forgiven loans as debt.” in my comment @ 6 should read ” So, I don’t have a problem with treating forgiven loans as income.”

  • DonS

    It is these other more hidden aspects of the “fiscal cliff” which Republicans should be using to leverage a president who is clearly only interested in scoring political points. I think that the Republicans should pass legislation making the Bush tax cuts permanent on all but the top two brackets, essentially conceding the top two brackets, as Obama has demanded. However, they should, in that legislation, eliminate the Alternative Minimum Tax, which is a bane to the existence of many middle class two-earner households, and eliminate complicated phase-outs and deduction and credit limits for high – earners, so that everyone is treated the same and tax returns are greatly simplified. Extending certain popular programs such as extended unemployment benefits and the mortgage debt forgiveness act will induce the Senate and president to pass/sign the legislation. Then, with these issues out of the way, both sides get a “win”, and the debt limit is the inducement to negotiate a more comprehensive overhaul of taxes, entitlements, and other spending programs.

  • DonS

    It is these other more hidden aspects of the “fiscal cliff” which Republicans should be using to leverage a president who is clearly only interested in scoring political points. I think that the Republicans should pass legislation making the Bush tax cuts permanent on all but the top two brackets, essentially conceding the top two brackets, as Obama has demanded. However, they should, in that legislation, eliminate the Alternative Minimum Tax, which is a bane to the existence of many middle class two-earner households, and eliminate complicated phase-outs and deduction and credit limits for high – earners, so that everyone is treated the same and tax returns are greatly simplified. Extending certain popular programs such as extended unemployment benefits and the mortgage debt forgiveness act will induce the Senate and president to pass/sign the legislation. Then, with these issues out of the way, both sides get a “win”, and the debt limit is the inducement to negotiate a more comprehensive overhaul of taxes, entitlements, and other spending programs.

  • Cincinnatus

    I’m with Dan Kempin here: forgiven debt is income. This seems to me unambiguous.

    …and for the first time I side with the IRS. Alert the press.

  • Cincinnatus

    I’m with Dan Kempin here: forgiven debt is income. This seems to me unambiguous.

    …and for the first time I side with the IRS. Alert the press.

  • Cincinnatus

    Oh, and tax forgiveness on debt forgiveness is precisely the kind of well-intentioned policy that ultimately undermines the civic virtues necessary for a flourishing republic–basic virtues like responsibility, honesty, thrift, and a fundamental willingness to deal with the consequences of one’s choices.

  • Cincinnatus

    Oh, and tax forgiveness on debt forgiveness is precisely the kind of well-intentioned policy that ultimately undermines the civic virtues necessary for a flourishing republic–basic virtues like responsibility, honesty, thrift, and a fundamental willingness to deal with the consequences of one’s choices.

  • DonS

    Cincinnatus @ 10, 11: Is your position without equivocation, i.e. without concern about the fact that capital losses aren’t freely deductible in the same way that capital gains are almost always taxable (with the residential partial exclusion on principal homes being the only exception I can think of?) In the case of a bad loan which is ultimately forgiven, shouldn’t the lender be able to deduct from ordinary income the amount of the forgiven loan, just as the debtor has the bad loan added to HIS income? And do you consider there to be a different moral equation when the homeowner has suffered a capital loss on his home purchase price, as opposed to another homeowner who refinanced his home to take cash out, bought boats and toys with the cash, and now needs a short sale to get out from under his poor choices?

    I basically agree with your position, but there is nuance here, and an opportunity to correct injustices in our tax code that work to the favor of government.

  • DonS

    Cincinnatus @ 10, 11: Is your position without equivocation, i.e. without concern about the fact that capital losses aren’t freely deductible in the same way that capital gains are almost always taxable (with the residential partial exclusion on principal homes being the only exception I can think of?) In the case of a bad loan which is ultimately forgiven, shouldn’t the lender be able to deduct from ordinary income the amount of the forgiven loan, just as the debtor has the bad loan added to HIS income? And do you consider there to be a different moral equation when the homeowner has suffered a capital loss on his home purchase price, as opposed to another homeowner who refinanced his home to take cash out, bought boats and toys with the cash, and now needs a short sale to get out from under his poor choices?

    I basically agree with your position, but there is nuance here, and an opportunity to correct injustices in our tax code that work to the favor of government.

  • Cincinnatus

    DonS:

    Sure, I think the creditor should also be able to deduct any losses attendant to forgiven debt. I never indicated anything to the contrary (though it seems to me that the incentives produced by forgiving debt are more morally corrupting to the debtor rather than the creditor).

    However, I don’t think we ought to oppose counting forgiven debt as income for debtors unless/until we apply the same economic/political/moral calculus to creditors. That would be a case of the perfect cannibalizing the good.

  • Cincinnatus

    DonS:

    Sure, I think the creditor should also be able to deduct any losses attendant to forgiven debt. I never indicated anything to the contrary (though it seems to me that the incentives produced by forgiving debt are more morally corrupting to the debtor rather than the creditor).

    However, I don’t think we ought to oppose counting forgiven debt as income for debtors unless/until we apply the same economic/political/moral calculus to creditors. That would be a case of the perfect cannibalizing the good.

  • DonS

    Cincinnatus: Hmm. I would phrase it “the better cannibalizing the worse”, or something like that, as there is nothing I can see inherently good or perfect in an intrusive, confiscatory income tax policy.

    In the case where the debtor has suffered a capital loss due to market conditions (probably worsened by horrific government economic policy), and thus has realized no real benefit from forgiven mortgage debt other than relief from a crushing obligation, would you not agree that the debtor should be able to deduct any imputed income from the short sale against his capital losses on the home? That would weed out true hardship from those who view their home as a bank and refinance to buy toys.

  • DonS

    Cincinnatus: Hmm. I would phrase it “the better cannibalizing the worse”, or something like that, as there is nothing I can see inherently good or perfect in an intrusive, confiscatory income tax policy.

    In the case where the debtor has suffered a capital loss due to market conditions (probably worsened by horrific government economic policy), and thus has realized no real benefit from forgiven mortgage debt other than relief from a crushing obligation, would you not agree that the debtor should be able to deduct any imputed income from the short sale against his capital losses on the home? That would weed out true hardship from those who view their home as a bank and refinance to buy toys.

  • Dr. Luther in the 21st Century

    Just out of curiosity, those of you who arguing over whether or not forgiven debt should be considered income or not based on reciprocity. Are any of you familiar at all, with what the creditor can or cannot write off on their taxes? Just a quick glance at corporate tax rules suggest reciprocity may already be in place. I am still looking, but what I am seeing is making me wonder about this conversation.

  • Dr. Luther in the 21st Century

    Just out of curiosity, those of you who arguing over whether or not forgiven debt should be considered income or not based on reciprocity. Are any of you familiar at all, with what the creditor can or cannot write off on their taxes? Just a quick glance at corporate tax rules suggest reciprocity may already be in place. I am still looking, but what I am seeing is making me wonder about this conversation.

  • DonS

    Dr. Luther: Yeah, I probably overstated my case. C corporations can deduct totally worthless debt and partially worthless secured debt from ordinary income. I misread the code earlier — it says “only if the loan was previously reported as income or if the loan was made from cash reserves” — the last part seems to allow deductions even if it was not previously reported as income. So, the banks are covered (shocker). However, seller financing by non-C corporations does appear to be limited to reporting as a short term capital loss, with its attendant limitations (only deductible to the extent it matches reported capital gains plus $3,000 ordinary income) when the seller is not in the business of making loans.

    Moreover, the larger point I was making was directed to the fact that many (most) short sellers have suffered a capital loss on the home they purchased. It’s not like they are walking away with a windfall when the bank agrees to forgive a portion of their mortgage because of a short sale. They are out every penny of their down payment plus all of their mortgage payments. Our tax system is set up so that the government is a partner in every profitable enterprise you have, but wants little or nothing to do with sharing your losses. I think that if capital gains are to be fully taxable, capital losses should be similarly fully deductible. Particularly since a lot of your capital gain is just recovering inflation anyway.

  • DonS

    Dr. Luther: Yeah, I probably overstated my case. C corporations can deduct totally worthless debt and partially worthless secured debt from ordinary income. I misread the code earlier — it says “only if the loan was previously reported as income or if the loan was made from cash reserves” — the last part seems to allow deductions even if it was not previously reported as income. So, the banks are covered (shocker). However, seller financing by non-C corporations does appear to be limited to reporting as a short term capital loss, with its attendant limitations (only deductible to the extent it matches reported capital gains plus $3,000 ordinary income) when the seller is not in the business of making loans.

    Moreover, the larger point I was making was directed to the fact that many (most) short sellers have suffered a capital loss on the home they purchased. It’s not like they are walking away with a windfall when the bank agrees to forgive a portion of their mortgage because of a short sale. They are out every penny of their down payment plus all of their mortgage payments. Our tax system is set up so that the government is a partner in every profitable enterprise you have, but wants little or nothing to do with sharing your losses. I think that if capital gains are to be fully taxable, capital losses should be similarly fully deductible. Particularly since a lot of your capital gain is just recovering inflation anyway.

  • Cincinnatus

    DonS:

    My point was largely ethical, not political, and I’m not an expert on the intricacies of the tax code, and the status of housing therein.

    But I will say this: isn’t the fact that we use the language of “capital” and treat housing as commodified profoundly problematic, and indeed the reason for our current economic crisis in the first place? Since when are homes considered “capital” in the same way that stocks and bonds are considered capital for tax purposes? When you sell a home, you pay sales taxes and the like, not income taxes. Am I missing something?

    Another potential problem: say I bought a home twenty years ago in a nice neighborhood for 200k, thinking I would stay there forever. In the two decades since, however, the neighborhood went downhill and the economy collapsed. The house is now only worth 100k. I sell, and I obviously take a loss, in order to get out. Should I be able to write off that two-decade-old loss as lost income? I can’t really justify why I should be able to do that.

    At some point, we have to be able to accept that sometimes we take our losses–we can’t blame others, and we can’t expect “mercy” or loopholes to soften the blow.

    I mean, I’m sympathetic to your general point. But, first, they’re two different issues (the original issue being whether forgiven debt should be considered as income–as it should). And second, I’m concerned about the potential ethico-political problems noted above.

  • Cincinnatus

    DonS:

    My point was largely ethical, not political, and I’m not an expert on the intricacies of the tax code, and the status of housing therein.

    But I will say this: isn’t the fact that we use the language of “capital” and treat housing as commodified profoundly problematic, and indeed the reason for our current economic crisis in the first place? Since when are homes considered “capital” in the same way that stocks and bonds are considered capital for tax purposes? When you sell a home, you pay sales taxes and the like, not income taxes. Am I missing something?

    Another potential problem: say I bought a home twenty years ago in a nice neighborhood for 200k, thinking I would stay there forever. In the two decades since, however, the neighborhood went downhill and the economy collapsed. The house is now only worth 100k. I sell, and I obviously take a loss, in order to get out. Should I be able to write off that two-decade-old loss as lost income? I can’t really justify why I should be able to do that.

    At some point, we have to be able to accept that sometimes we take our losses–we can’t blame others, and we can’t expect “mercy” or loopholes to soften the blow.

    I mean, I’m sympathetic to your general point. But, first, they’re two different issues (the original issue being whether forgiven debt should be considered as income–as it should). And second, I’m concerned about the potential ethico-political problems noted above.

  • DonS

    Cincinnatus @ 18: I don’t really think we are in violent disagreement here. I completely agree that, in general, forgiven loans should be imputed as income to the debtor and deductible by the lender. And, I guess, as long as the lender is in the business of lending, that is generally the case. My only point was for the case covered by this statute — where an owner loses their home because of economic circumstances where they cannot afford to continue the mortgage payments and the home has dropped in value below the remaining balance on their purchase money loan (i.e. where they haven’t refinanced to take out cash for other purposes). This owner has suffered a capital loss which exceeds any gain they receive by being forgiven the excess debt over the short sale value, and to hang a tax liability on top of that loss seems cruel and lopsided. He hasn’t done anything ethically wrong except purchase his home at the wrong time.

    As for your point:

    Another potential problem: say I bought a home twenty years ago in a nice neighborhood for 200k, thinking I would stay there forever. In the two decades since, however, the neighborhood went downhill and the economy collapsed. The house is now only worth 100k. I sell, and I obviously take a loss, in order to get out. Should I be able to write off that two-decade-old loss as lost income?

    Absent the politically motivated exemption for capital gains for your principal residence, up to $500,000, if there were a capital gain on the home you would pay the tax on that capital gain in the year you sold the home. So why shouldn’t you be able to claim the capital loss in the same way? There’s no reason why you shouldn’t be able to, at least at the same capital gains tax rate you would pay on a gain. But, the law says that you can only deduct capital losses to the extent they match capital gains, plus $3,000, in one year. The rest of the loss has to be carried over to future years, when it will be under the same restriction. That’s the asymmetry I am talking about.

  • DonS

    Cincinnatus @ 18: I don’t really think we are in violent disagreement here. I completely agree that, in general, forgiven loans should be imputed as income to the debtor and deductible by the lender. And, I guess, as long as the lender is in the business of lending, that is generally the case. My only point was for the case covered by this statute — where an owner loses their home because of economic circumstances where they cannot afford to continue the mortgage payments and the home has dropped in value below the remaining balance on their purchase money loan (i.e. where they haven’t refinanced to take out cash for other purposes). This owner has suffered a capital loss which exceeds any gain they receive by being forgiven the excess debt over the short sale value, and to hang a tax liability on top of that loss seems cruel and lopsided. He hasn’t done anything ethically wrong except purchase his home at the wrong time.

    As for your point:

    Another potential problem: say I bought a home twenty years ago in a nice neighborhood for 200k, thinking I would stay there forever. In the two decades since, however, the neighborhood went downhill and the economy collapsed. The house is now only worth 100k. I sell, and I obviously take a loss, in order to get out. Should I be able to write off that two-decade-old loss as lost income?

    Absent the politically motivated exemption for capital gains for your principal residence, up to $500,000, if there were a capital gain on the home you would pay the tax on that capital gain in the year you sold the home. So why shouldn’t you be able to claim the capital loss in the same way? There’s no reason why you shouldn’t be able to, at least at the same capital gains tax rate you would pay on a gain. But, the law says that you can only deduct capital losses to the extent they match capital gains, plus $3,000, in one year. The rest of the loss has to be carried over to future years, when it will be under the same restriction. That’s the asymmetry I am talking about.

  • Grace

    There are people, we know, who purchased a condo, about four to five years ago, and then over a year and a half ago, did a short sale. Before they moved, they leased a home for 3,ooo per month, purchased some new furniture for the living room, etc. There were other things, but this gives you an idea of what happened.

    They also have a Range Rover, two years old, at about 65K and another SUV, which is older.

    To top it off, both of their children attend private school, which runs about 1,400 per month.

    I wonder how many others are doing these types of things. It’s troubling to see anyone, who appears to be ‘gaming the system.

    Obviously we don’t interact with them any longer.

    I’m interested in your opinions.

  • Grace

    There are people, we know, who purchased a condo, about four to five years ago, and then over a year and a half ago, did a short sale. Before they moved, they leased a home for 3,ooo per month, purchased some new furniture for the living room, etc. There were other things, but this gives you an idea of what happened.

    They also have a Range Rover, two years old, at about 65K and another SUV, which is older.

    To top it off, both of their children attend private school, which runs about 1,400 per month.

    I wonder how many others are doing these types of things. It’s troubling to see anyone, who appears to be ‘gaming the system.

    Obviously we don’t interact with them any longer.

    I’m interested in your opinions.

  • http://www.toddstadler.com/ tODD

    Grace (@19) said:

    I’m interested in your opinions.

    I think you’re a busy-body and a gossip.

  • http://www.toddstadler.com/ tODD

    Grace (@19) said:

    I’m interested in your opinions.

    I think you’re a busy-body and a gossip.

  • Grace

    No tODD, you’re wrong. I mentioned no name, or any other identification. You nor anyone else, knows who I’m referring to.

    POOR tODD, strikes out again! :razz:

  • Grace

    No tODD, you’re wrong. I mentioned no name, or any other identification. You nor anyone else, knows who I’m referring to.

    POOR tODD, strikes out again! :razz:

  • http://www.toddstadler.com/ tODD

    Grace (@21), it’s sad that you think leaving out that one detail somehow makes you not a busy-body or a gossip. That’s legalism for you, I guess.

    As I suspected, you weren’t really interested in hearing our opinions.

  • http://www.toddstadler.com/ tODD

    Grace (@21), it’s sad that you think leaving out that one detail somehow makes you not a busy-body or a gossip. That’s legalism for you, I guess.

    As I suspected, you weren’t really interested in hearing our opinions.

  • Grace

    tOOD, POOR, POOR tODD

    You don’t know my friends or acquaintances, or those I do business with – I didn’t give enough information so that anyone would know anyone’s name – that includes my closest friends, they would have no clue as to whom I was referring to.

    You have little to say, so instead you PICKY NIT whatever you can. :roll:

  • Grace

    tOOD, POOR, POOR tODD

    You don’t know my friends or acquaintances, or those I do business with – I didn’t give enough information so that anyone would know anyone’s name – that includes my closest friends, they would have no clue as to whom I was referring to.

    You have little to say, so instead you PICKY NIT whatever you can. :roll:

  • http://www.toddstadler.com/ tODD

    Grace (@23), I don’t want to know your friends or acquaintances! I’d spend all my time wondering if they were the ones you’d been gossipping about online, putting your nose all up in their business where it doesn’t belong, as if you needed to know or anyone else cared.

    Oh, but that’s right. You don’t interact with them any longer. So how rich do I have to be to get that treatment from you?

  • http://www.toddstadler.com/ tODD

    Grace (@23), I don’t want to know your friends or acquaintances! I’d spend all my time wondering if they were the ones you’d been gossipping about online, putting your nose all up in their business where it doesn’t belong, as if you needed to know or anyone else cared.

    Oh, but that’s right. You don’t interact with them any longer. So how rich do I have to be to get that treatment from you?


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