September 24, 2007

Band-Aid On A Bullet Wound

(c) copyright View from Silicon Valley, 2007.  All rights reserved.

In the course of  most weeks, we all see, hear and read a lot of commentary about the housing market.  Such commentary lately focuses on various measures invented to combat the now-acknowledged fall in house prices.

We all accept that many of these are just obvious the "spin" of interested parties. Realtors, banks, mortgage brokers, planning commissions and politicians each shamelessly touts their preferred set of facts.

However, when the local paper puts out something loaded with slanted adjectives and opinions as though they were objective facts, it still stands out.  Today's example is was, "Forgiveness in foreclosure could mean tax surprise," with the sub-title, "BILL IN CONGRESS TO EASE BURDEN ON DEBT-RIDDEN HOMEOWNERS," by Susan Tompor.

We will try to point out we think are the most egregious examples of spin (all emphasis added):
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The last thing somebody who couldn't pay the mortgage would expect is a tax document in the mail that proclaims they magically got an extra $20,000 in income they never touched.  (The opening sentence immediately disposes of the notion this will be a calm, rational discussion of facts...)

But that's exactly the tortured tax picture that faces many troubled homeowners.  (Yes, let's make sure the reader knows what you want them to think of the tax code before you present any actual facts.)

Thousands of families could face an unexpected tax hit if they went through foreclosure, worked out some unusual deals with the bank to refinance or sold homes for less than the outstanding debt.

"This really adds insult to injury where someone is in a situation where they get hit with a tax bill on top of having to lose their house or refinance at a lower value," said U.S. Sen. Debbie Stabenow, D-Mich.

Stabenow wants to see this unfair tax rule change by year's end. On Aug. 31, President Bush gave his support to Stabenow's mortgage relief act as part of his package to assist homeowners.  (No tax rule objectively agreed to be unfair has ever been passed.  In reality, this tax rule was created to prevent guys like Donald Trump from loaning Ivanka or Donald, Jr. millions of dollars and then "forgiving" the loan.  The Donald's "forgiveness" generates a big tax deduction for himself while his kids get the money tax-free.  Does preventing such a maneuver sound like an "unfair tax rule" to you?)

It's one of those tax rules that not many people know about because home values have typically gone up, not down. Yet, it's a tax issue that now could have great impact on families throughout the country.

Say a homeowner loses a job, needs to move and has to sell the house for $80,000 instead of the $100,000 owed on the mortgage. If the bank forgives $20,000, as is possible in some cases, it's going to generate a 1099 tax form that has to be reported as income.  (Can we get somebody to question for a moment why a buyer living a few paychecks from insolvency should buy a $100K or $120K house?)

For many families, an extra $20,000 on that 1099 could mean that they've got to dish out an extra $3,000 to $5,000 or more in federal income taxes.  (Again, if it was reasonable for this person to buy a $120K house, why is it unreasonable for them to pay another $3K or $5K in taxes?  Unless they're now conceding many people had no business buying such a house in the first place?)

"The general rule is that cancellation of debt is taxable income," said Bob D. Scharin, RIA senior tax analyst from Thomson Tax & Accounting.  (Yes, let's use a "senior tax analyst" to pronounce this obvious fact so that people will assume it's some kind of rocket science.  Otherwise, an inability to get something for nothing might seem like-- I don't know -- common sense?)

Or take another possibility. The family can no longer make the mortgage payments. So the family negotiates with the bank and attempts to do what's called a short sale - or sell the property for less than the debt owed on the mortgage. The bank may forgive part of the loan. Again, though, we're looking at another tax hit.  (Sorry, that's not "another tax hit," it's still the same thing.  Can we please get editors and reporters to report facts without shamelessly inventing drama?)

Or how about a homeowner who is able to pay the mortgage at the initial adjustable rate? But then the rate readjusts upward significantly - and suddenly the mortgage payment is unaffordable.  (In other words, they now concede more than a few of the fools who drove up house prices the last three years never understood their financing.  Now the bank gets a write-off with no offsetting bill to the defaulting buyer?  Who pays the IRS to offset the taxes "lost" due to the bank write-offs?  Oh, that's right --the rest of us!)

Say the homeowner would like to refinance.

But there's a snag. Some homes now are being valued below the original mortgage taken out three, four or five years ago. So the house might be valued at $100,000 instead of $120,000.  (Conceding it's common that many buyers over-paid.)

And the homeowner might not have enough equity in the house to deal with the difference. (Conceding it was OK to over-pay AND not put 20% down.)

If the bank steps in and refinances the house at $100,000 instead of $120,000, well, the homeowner still would run up against that tax hit.

"It's typically not a gift. It's considered income - just like when you win a prize," said Gary Riedlinger, tax research manager for Yeo & Yeo PC in Saginaw.

Except nobody feels like a Lotto winner.

In some cases, consumers are able to avoid the tax hit.

"The one big exception is bankruptcy," said James Jenkins, president of Jenkins & Co., a tax firm in Southfield, Mich.  (At last, somebody states the obvious.)

If the debt is discharged in bankruptcy, the tax isn't owed. (So why are we even having this discussion?  The tax code already provides a solution!!)  Another option: Taxpayers could file a complicated tax form, Form 982, to show that they were insolvent - or had more debts than assets.  (Well, if we're conceding it's somehow my fault that you bought a $120K house without understanding your financing, heaven forbid we should expect you to trouble your simple little mind with reading a tax form.  If you emerge for a moment from your victim mentality and finally stop to actually think, you might deduce a politician is likely to volunteer to decipher this "complicated" form for you.)

"How's the average guy going to possibly know the rules on this?" Jenkins asked, noting that an experienced tax preparer could save some consumers money and avoid much of the tax.  (Politicians already conceded that expecting a $120K buyer to pay $3K in taxes is unreasonable.  Therefore, it only stands to reason they then also concede shelling out for an accountant is also out of the question --right?  Once buyer's have no responsibility for spending $120K, why bother trying to make them pay $100?)

But Jenkins agreed that the rules should be changed to help families during this mortgage mess.

"Sad to say, it's going to be a very common problem," Jenkins said. "You're not ending their misery if they're going to end up with a big, fat tax bill." (If the politicians stay out of the way, maybe we're ending the misery for those of who chose not to buy houses at ridiculously-inflated prices...)

Stabenow told me that she's willing to make this a temporary change, possibly for a year or two, in order to get bipartisan support. (Oh right!  This tax cut will expire --just like Bush's tax cuts, or California's "VLF discount" which helped sweep Gray Davis out of office when he tried to re-instate it.)

She also is willing to limit the tax change to the homeowner's primary residence.

Stabenow noted that many middle-class families have borrowed money to get into a house in a better school district - and improve their situation.  (If they improved their situation, it was at the expense of those who bit the bullet and chose not to over-pay.)

She said the banks support the tax rule change because they don't make money foreclosing on homes.  (This is mostly false, but hard to explain within this reporter's one-sentence-is-enough-to-explain-everything article.  In short, it's mostly not the bank's decision. Banks' mortgages were sold off as bonds long ago.  Bondholders' inability to judge the value of these houses will make re-negotiations difficult.  Bondholders may see foreclosure as a "safer" decision.)

Richard DeKaser, chief economist for National City in Cleveland, said lenders would have more flexibility in renegotiating terms and avoiding some foreclosures if some proposals went through, including a temporary freeze on the tax burden - as Bush and Stabenow are proposing.

Changing the tax rules - even just for a year or two - won't get rid of the For Sale signs in everyone's neighborhood or cut off the wave of foreclosures. But Stabenow's plan certainly is a sensible, solid step toward fixing an unforeseen problem for many families.

This last paragraph hints at the only objective truth in this article.  Even if this bail-out measure passes, it's a band-aid on a bullet wound.  It might temporarily slow the bleeding, but the housing patient will continue to bleed...