Homeowners sitting in upside-down status with properties thousands of dollars underwater may find themselves begrudgingly making payments on residences no longer worth their original values — or even worse, tempted to strategically default to escape their debts, leaving banks to absorb those losses.
Shared appreciation — a borrowing concept in which a lender writes down a principal mortgage debt to the property’s current market value in exchange for a share of the profit when the home is refinanced or sold — is not without its critics.
Many believe shared appreciation remains stifled by tax concerns, and a missing legal structure. There is also a general unwillingness among financial firms and borrowers to engage in a process they find historically untested.
In other words, shared appreciation is talked about, lauded and yet the catch-on rate for this program is lackluster, despite a strong push for it in the years following the housing meltdown.
And despite the continuing debate over whether these programs can work long-term, the window for shared appreciation to catch on as a widespread trend has all but closed, with home values now rising on a consistent basis.
The indication is that homeowners won’t be as willing to divvy up any chance of making money on their property investment. Shared appreciation, it seems, cannot compete with a silver lining.
In a housing market where the National Association of Realtors notes that existing-home sales declined 3.2% to an annual rate of 5.12 million units in October 2013 — and where the median home price rose 12.8% from year-ago levels — the need to write down debt is becoming less of a concern for lenders and borrowers alike.
Gagan Sharma, CEO of Dallas-based mortgage servicer BSI Financial, says changes in the marketplace make shared appreciation less of a talking point in the current model. It’s a concept his firm is not using, with BSI often preferring more precise and cleaner solutions that are intuitive to the borrower’s sense of openness and fairness.
“At one point, there was a lot more conversation about shared appreciation,” he said, “but that seems to have gone away.”
Sharma blames the nascent housing recovery for a decline in shared appreciation discussions. He says in many cases, borrowers are pulling themselves out of negative equity positions without the help of servicers and regulators.
“As house prices continue to go up, there are fewer borrowers in a negative equity position,” Sharma explained.
Furthermore, he believes even more borrowers are closer to the point of moving out of their underwater state, giving them more equity to play with as they craft solutions. “In the case of shared appreciation, a borrower is saying, ‘I will make my regular mortgage payment, but I will give up my piece of the appreciation,’” Gagan noted.
Shared appreciation never became a large-scale program in the U.S. during the housing crisis. In the United Kingdom, however, the concept is huge.
The British federal government uses no less than four variations of the product in helping to push homeownership, especially among the first-time homebuyer base. Using shared appreciation, in fact, is a right to tenants in government-subsidized housing in the Kingdom.
Even in homes where the local council sold it to a private landlord there is still the “Preserved Right to Buy” scheme in which the tenant can convert to ownership using shared appreciation. In the United States, however, the mortgage servicer fabric is very different and their interests are not always aligned with the fact that shared appreciation remains a non-government product.
As a servicer, BSI's Sharma said he has seen more interest in the Hardest-Hit Fund, a government program that distributes funding to pull borrowers out of their negative equity positions without tacking on the confusion of shared appreciation down the road.
And there’s also an undercurrent of negative feeling about the risks associated with shared appreciation programs, especially if they are not crafted and advertised the right way.
“There is a perception that the servicer is taking some equity from the borrower,” Gagan noted.
There are risks from the servicer’s side, as well, if home prices don’t actually rise. “It’s a risk servicers don’t want to necessarily take,” he noted. “We would rather offer a simpler, cleaner product for the borrower.”
One of his fears is that a borrower using shared appreciation may come back later on and claim they never understood the terms of the original agreement when a payout is required at the end.
But shared appreciation programs and negative equity borrowers remain realities in today’s housing market — albeit realities that are not as prevalent, or talked about, when compared to a few short years ago. November data from Zillow shows roughly 10.8 million American homeowners still underwater, a significant portion of today’s housing market. This is where shared appreciation steps in as a possible resolution for these borrowers.
Ocwen Financial Corp. confirmed that a shared-appreciation program launched by the mega servicer a few years back for underwater borrowers is still in effect. The initiative captured a great deal of market attention in 2011 with Ocwen rolling out a shared appreciation modification (SAM) program designed to take the borrower’s principal down to 95% of the home’s current market value.
In exchange, the written-down portion of the loan is forgiven in one-third segments over a course of three years as long as the borrower remains current. If the home resells or refinances, the borrower is then required to turn over 25% of any appreciation to investors, while borrowers keep 75% of the gains.
Ocwen says its internal SAM program has lifted approximately 42,000 families out of negative equity positions, saving them on average $520 per month. “The program was designed to help us address the underwater mortgage problem,” said Paul Koches, executive vice president of Ocwen. “And while the mortgage crisis is subsiding to some degree, the underwater mortgage problem remains daunting in many of the hardest-hit markets.”
Koches says Ocwen’s program met its mandate, providing an option for underwater borrowers while also achieving a positive net-to-present value outcome for investors.
“We are very pleased with the success of the program. We track re-defaults, and I can tell you that re-defaults on the same program are lower than industry average,” he said.
Data released by Ocwen puts re-defaults on SAMs from the programs inception-to-date at around 10%.
Promoted at its launch as a program that helps borrowers avoid foreclosure and restore equity, Ocwen received praise from homeownership advocates early on.
John Taylor, president and CEO of the National Community Reinvestment Coalition, lauded the Ocwen program at the time of its rollout and remains a steadfast fan of shared appreciation programs. Yet even Taylor recognizes some of the tax implications and areas of confusion that surface during the process of writing down debt in exchange for shared equity.
Despite his support of the program, he believes the Ocwen initiative failed to catch on nationwide. “I was familiar with Ocwen’s shared appreciation program, which I thought was a very good model,” he noted. “The key is the homeowner is able to grow their equity, but there is a reward in it for the lender and the investor to share in the appreciation, but not disproportionately.”
But tax considerations remain a sticking point for shared appreciation initiatives; so much so that they may keep lenders and borrowers from leaning heavily on these deals.
The problem tax-wise, Taylor suggests, is that “if shared appreciation results in a reduction of the mortgage, technically speaking you have realized a gain (as the borrower), that is current tax law.”
He noted that on the most basic level, a reduction on your mortgage generally means you pay taxes on that as a gift. But with a shared appreciation modification, the reduction is not always permanent since profits at the end of the life of the loan could end up resulting in investors gaining the money back from the borrower upon the home’s eventual sale.
So is a borrower taxed on the write-down early on or is the lender taxed? And who is taxed at what time?
The problem is, there is currently no definitive answer to these questions. But the tax treatment can often prove costly or at least risky in theory.
Three researchers developed a report for the Benjamin Cardozo School of Law at Yeshiva University, noting “the current tax rules make it essentially impossible to develop SAM (shared appreciation mortgage) markets in the U.S.” The report, “Rectifying the Tax Treatment of Shared Appreciation Mortgages,” was written by Andrew Caplin, an economics professor with New York University; Noel Cunningham with the New York University School of Law; and Mitchell Engler with the Benjamin Cardoza School of Law.
A large part of the report discusses the tax treatment of SAMs during the home purchase process, but the issue remains the same when it comes to negative equity situations. Essentially, the tax treatment of SAMs is unclear, and the Internal Revenue Service has yet to create a definitive solution to satisfy the demands of tax attorneys and the business community.
This would not be the case if there were government involvement, of course, as there is in Britain, but no one seems interested in seeing more federal handiwork in the mortgage market.
In Britain, where shared appreciation is also highly scrutinized, there is less of a backlash against the product itself, but rather those who innappropriately service the shared appreciation. Stateside, Uncle Sam is still doing his best to slowly get out of housing.
Caplin, one of the study's co-authors, suggested in an interview with HousingWire that these lagging tax issues alone remain a barrier to a robust SAM market — and this has been an area of contention since the mid-1980s.
“I find our inability as a society to embrace this kind of risk-sharing very sad,” Caplin noted. “They make it very hard.”
In a related white paper and policy update published on The Brookings Institution website, Caplin and several other researchers reported on the tax treatment of SAMs, noting that in 1986 the Treasury placed SAMs on its no-rulings list, preventing any definitive rulings on how to tax a product in which a homeowner gets this type of benefit up front.
The Caplin paper also pointed to a 1996 Treasury ruling that tried to clarify the tax treatment for SAMs, but did so in a punitive way.
“Investors would have to pay taxes on income from the SAM prior to receiving the payment, while borrowers could not claim a deduction for this payment until it was made,” the research report said. “By treating borrowers and lenders asymmetrically, the ruling creates a substantial tax cost,” the white paper noted.
FEDERAL LEGISLATION TO THE RESCUE
A shared appreciation foreclosure-prevention program tied to Boston Community Capital has managed to successfully deal with all of the tax implications stemming from its initiative, thanks to a temporary federal law that expires in late 2013.
Boston Community Capital CEO Elyse Cherry spent the final part of 2013 urging lawmakers to extend the expiring Mortgage Forgiveness Debt Relief Act so her firm can continue saving distressed homeowners through the company’s comprehensive Shared Appreciation Initiative. Cherry’s tax fears are occurring at a time when not only is BCC’s program doing well, it’s expanding into other hardest-hit housing markets.
Her company’s initiative, better known as the Stabilizing Urban Neighborhoods, or SUN program for short, has already saved more than 425 families from foreclosure in Massachusetts. SUN is an investor-financed initiative that buys underwater homes from lenders at the current fair market value. In turn, BCC sells the homes back to the original homeowner at a lower price.
Foundations and private investors bankroll SUN, so it poses no loss to state or federal taxpayers. It’s also a boon to the many foreclosure-riddled communities that would otherwise be facing more empty properties and falling home values.
Recognizing the many benefits of SUN, Boston Community Capital decided to expand its initiative outside the borders of the Bay State, with a rollout of the program in Maryland during the fall of 2013. Eventually, the plan is to take it nationwide, Cherry said.
“We have a robust set of systems that allow for the expansion to other jurisdictions,” Cherry told HousingWire. Jurisdictions struggling with foreclosures are the bank’s primary targets.
Once SUN convinces a lender to sell a borrower’s loan at the distressed market value, SUN resells it to the borrower, attaching a more affordable fixed-rate, 30-year mortgage. On average, participating homeowners see their monthly payments and principal balances reduced by 40%, Boston Community Capital noted.
But the program is not for everyone. There are eligibility standards to protect the integrity of what BCC is offering homeowners. Borrowers are required to go through a full underwriting process to prove their missed payments are the result of a significant hardship, such as illness or job loss. And no one enters the program without going through stringent underwriting, the bank’s CEO pointed out.
“We don’t lend unless we know the borrower is able to repay the loan,” Cherry said.
And to protect against fraud, Boston Community Capital incorporates a shared appreciation function that forces borrowers to give up a portion of any gains made on the property over time if the home is ever refinanced or sold. This is where the temporary Mortgage Forgiveness Debt Relief Act steps in.
Typically, Cherry says any forgiven debt is viewed as income without this temporary law in place. Under the practice of shared appreciation, the homeowner is still technically getting income through the initial principal reduction by IRS standards, but Cherry describes this as “phantom income” since the borrower is not actually gaining any financial benefit from the transaction.
In the past few years, the issue of taxation on shared appreciation has not been a problem, Cherry says, because the statute has been tightly in place and extended each year.
“My own sense is that treating forgiven mortgage debt as imputed income is a challenge that should be permanently fixed,” Cherry said. After all, without it, BCC’s innovative program is back to square one just as it’s starting to expand across the country.
She added, “If the MFDRA expires, it will be far more difficult for struggling homeowners to participate in our SUN Initiative.”
“That’s unfortunate because the foreclosure crisis continues in low-income communities,” she said. “A failure to renew the MFDRA will result in a tax penalty on money that people never received. That’s a high barrier to participating in our program and others like it.”
BCC is just now gaining attention for offering shared appreciation at a time when other programs offering it are not as prominent. This alone creates a need for tax certainty, so the existing programs can move forward, the company says.
Cherry likes to discuss Fed Chairman Ben Bernanke’s reaction to her firm’s shared appreciation initiatives. With the Federal Housing Finance Agency — and other government housing agencies — often shooting down the idea of using principal reductions, this little program coming out of the non-government sector is pleasing to the eye for some regulators.
The Federal Reserve chairman referred to SUN as an “innovative strategy to prevent occupied homes from becoming vacant and creating a strain on the economy.”
With this in mind, Cherry says losing a popular bill designed to ensure tax certainty on programs like SUN would be a major blow for the housing market.
“The program only works when we can save homeowners money,” said Cherry. “If Congress doesn’t vote to extend the MFDRA it becomes more difficult to do that.”
A failure to keep the tax relief going for these programs will have a direct impact on the most vulnerable of homeowners, Cherry believes. “We read a lot about the market coming back,” she noted, adding that “we have a two-tier recovery where middle-income and upper-middle income are doing well and their homes are back in terms of value.”
On the other hand, Cherry says lower-income areas are still in a position where their homes are severely undervalued. So without the tax bill, the taxes will disproportionately impact borrowers in neighborhoods where negative equity is still a major issue.
THE GAMEPLAN IN CONGRESS
It's not as if members of Congress are entirely asleep at the wheel. As early as April, Rep. Gary Peters, D-Mich., introduced the Preserving American Homeownership Act of 2013 — a bill designed to introduce a pilot shared-appreciation mortgage modification program.
The bill, which was referred to committee and has made it no further, directed the head of the Federal Housing Finance Agency, the Federal Housing Commissioner and Treasury Secretary to create a shared appreciation modification program under the umbrella of the Making Home Affordable program.
The proposed initiative would reduce a borrower’s mortgage loan-to-value ratio to 115% by cutting the principal — with additional plans to slash the principal debt to 95% loan-to-value within three years through a series of annual reductions. In addition, the bill stipulated that interest rates could be reduced if a principal reduction failed to make a monthly payment affordable enough.
A homeowner under Peters’ plan would then have to pay the investor after selling or refinancing the property by the percentage of the amount of any increase, with a max at 50%. The idea of using principal reduction at the federal level continues to draw fierce debate, but the issue used to be trumped by the fact that former FHFA director Ed DeMarco had long said the rules of conservatorship do not include initiatives as aggressive as principal reduction.
On the other hand, the new FHFA director, Mel Watt, D-N.C., shows a propensity to value principal reductions. Watt is a very vocal supporter of certain aspects of housing finance that are seen as helping the greater good. Watt is on the public record championing housing advocacy, which may yet lead to a renewed interest in shared appreciation.
Whether rising home prices will quash Watt’s partiality toward principal reductions is unknown, but shared appreciation modifications continue to occur even when the market improves. It’s a solution that definitely caught on with at least a small percentage of the market.
The big issue is whether Congress or other regulators will ensure clarity when it comes to tax issues and lingering concerns about the long-term benefits of a shared-appreciate mortgage. If those issues are ever completely resolved, the programs may catch on. Until then, many programs will find it hard to gain meaningful momentum.