In late 2007 as Americans began to feel the crushing weight of the housing crisis, Congress passed the Mortgage Forgiveness Debt Relief Act. The legislation protected homeowners opting to cut a deal with their lender to sell their homes at a discount, through a process called a “short sale”, from debt cancellation tax being levied by the Internal Revenue Service.
The decision to enter into a short sale is made by homeowners and lenders, and is a recognition that it is simply the best option available for all parties. Classifying the debt forgiven during a short sale transaction as taxable income demonstrates a fundamental misunderstanding of the circumstances of the borrower and the lender. Levying draconian tax on distressed homeowners may not only drive them into bankruptcy, it also hurts struggling communities and the broader housing market.
Congressional passage of the Mortgage Forgiveness Debt Relief Act facilitated a crucial option for distressed homeowners, and recognized the reality that the government could not modify its way out of the housing crisis. In 2008 short sale activity nearly tripled with approximately 400,000 homeowners utilizing this vital transaction every year. The short sale tax break expired in 2013, and this year has seen short sales plummet nationwide to no more than three percent of existing home sales annually.
Short sales provide an opportunity for homeowners who are behind on their monthly payments, underwater, and facing hardships like being unemployed to walk away from their homes without suffering all the negative consequences of a foreclosure. The classification of the homeowner debt cancelled during a short sale as income allows the IRS to levy a hefty tax bill against Americans who were unable to pay their mortgage, thus burying them in further debt and making the use of the short sale transaction prohibitive.
Distressed homeowners are not the only casualties of the failure to extend this tax break. Communities hit hardest by the housing crisis bear the brunt of Congressional inaction as well. Many of these properties are abandoned or in disrepair, and thus do not fit into the models of many institutional real estate investors and are not a priority for real estate agents either. Thus the homes remain abandoned and broken down, hurting housing valuations in neighborhoods, denying state and local governments much needed tax revenue, and often lead to spikes in criminal activity.
Distressed properties are highly sought after by non-institutional private residential investors, and short sales are a crucial tool for these investors as a means to purchase the property, conduct the necessary repairs, and re-sell or lease the property to a qualified candidate. The threat of a massive tax penalty levied against struggling homeowners has prevented these investors from performing the essential work of re-building devastated communities one home at a time.
Another rarely mentioned yet important aspect to this issue concerns the “shadow” housing inventory. Estimated to be roughly 1.6 million homes, these are distressed properties where the homeowner is seriously delinquent or the property is abandoned, but the homes are not in active foreclosure or listed for sale. Institutional buyers have made a dent in the shadow inventory, as have government modification programs. Short sales are another powerful tool that can be used to normalize the shadow inventory numbers and return stability to the housing market.
The debate over extending the Mortgage Forgiveness Debt Relief Act comes down to providing assistance to homeowners, allowing devastated communities to recover from the housing crisis, and providing an essential tool to facilitate a full housing market recovery. Some may raise the issue of lost tax revenue. The revenue generated by taxing distressed homeowners utilizing short sales pales in comparison to the potential tax revenue from home sales and property taxes that will be realized through the execution of more short sale transactions. Also, the distressed homeowners didn’t have the money to pay their mortgage, therefore they also do not have the money to pay the tax bill since the bill is based on “phantom income.”
Congress cannot undo the damage to homeowners and communities already done in 2014 because this tax break is not available to distressed homeowners. However, extending the tax break through 2015 and making it retroactive to cover all of 2014 would be a good start. Congress should follow the leadership of Sen. Debbie Stabenow, D-Mich., and Sen. Dean Heller, R-Nevada, and move immediately to extend the bipartisan Mortgage Forgiveness Debt Relief Act before more damage is done.