People losing their homes can wind up losing more

Nation's Housing

July 16, 2000

THE FEDERAL tax code's most glaring penalty for unsuspecting homeowners - a double-whammy when they're down and out and can least afford it - appears finally to be on the verge of reform.

Two influential senators have begun pushing a bipartisan bill that would end the tax code's harsh treatment of homeowners who fall seriously behind on their mortgage payments and face imminent foreclosure.

Many homeowners in this situation turn to their lenders to work out some form of accommodation that avoids the crushing costs of foreclosure. Frequently the solution involves what's known as a "short sale," a quick transfer of the property to investors or others at less than the full market value of the house.

Sometimes lenders agree to forgive a portion of the homeowner's mortgage debt, thereby easing the financial burden on people in distress who've just lost their home. But instead of encouraging such benevolence, the federal tax code has a built-in poison pill for homeowners who accept mortgage debt forgiveness: The government treats every cent of forgiven mortgage debt as earned income by the home-owning taxpayer, taxable at regular income tax rates, even though the taxpayer may have just lost everything.

The Mortgage Cancellation Relief Act of 2000, co-sponsored by Democratic Sen. Bob Kerrey, of Nebraska, and Republican Sen. Orrin G. Hatch, of Utah, would remove the poison pill from the code, and free home sellers of their current debt-forgiveness tax burdens.

A nearly identical bill, co-sponsored by Democratic Rep. Robert E. Andrews, of New Jersey, and GOP Rep. Mark Foley, of Florida, already has passed the House. Since both Kerrey and Hatch are members of the tax-writing Senate Finance Committee, the odds that their bill will be included in any major congressional tax legislation this fall appear favorable.

To get a sense of how unfair the current law is, consider this hypothetical example. Say you bought a house for $150,000 with a $135,000 mortgage. Within the year you had some bad luck, got sick, couldn't continue working, and no longer had the monthly income to pay the mortgage. Your lender sent you delinquency notice after delinquency notice, and finally uttered the "F" word: Foreclosure.

But, like many in the mortgage industry, your lender would prefer to avoid the tens of thousands of dollars of costs to itself - real estate brokerage fees, legal expenses, property maintenance, etc. - involved in any foreclosure. The lender checked what your house would bring in a foreclosure sale, and found that it was about $125,000 - a full $10,000 less than your mortgage balance. Figuring in all the other costs, the lender calculated it would net just $100,000 out of the foreclosure - $35,000 less than the loan amount.

As a better alternative for both parties, the lender proposed a "workout" arrangement: Either you or a real estate agent find a buyer who'll purchase the property for $125,000, and the lender won't foreclose and won't pursue you for the $10,000 unpaid balance on the mortgage remaining after the sale.

Great idea, you thought, and you agreed. But unknown to you, the lender was required to report the amount of the debt you were forgiven to the IRS. And, at the end of the transaction, you:

Had no house or job,

Lost all your home equity, and,

Owed the federal government income taxes on the $10,000 mortgage debt that was forgiven.

Talk about hitting someone when he's down on his luck!

To remedy this tax code mean streak, the Senate bill - and its House-passed companion - would provide an exemption from federal income taxation for any amount a mortgage lender forgives a borrower on the sale of a principal home, provided the sale proceeds are insufficient to pay off the loan balance.

Besides "workout" situations, the bill would also have potentially significant application anytime a region of the country experiences widespread property value declines. Although that may sound like a remote possibility in today's roaring home appreciation marketplace, the fact is that home values historically are volatile. They don't only go up. Huge swaths of Southern California home real estate, for instance, suffered declines of 20 percent to 30 percent from their peaks in the late 1980s well into the mid-1990s. Residents of Texas and Oklahoma experienced similar losses in the 1980s.

Should the Mortgage Cancellation Relief Act become law, homeowners in such unpredictable real estate downturns should at least have one less worry: When they're down and out and forced to sell their property at a loss, federal tax collectors won't come demanding a final pound of flesh in the form of income taxes.

Kenneth R. Harney is a syndicated columnist. Send letters care of the Washington Post Writers Group, 1150 15th St. N.W. Washington D.C. 20071.

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