Underwater Homeowners Face A Tax Time Bomb

The letter from Bank of America Home Loans got right to the point. “We are pleased to inform you that we have approved your Home Equity Account for participation in a principal forgiveness program offered as a result of the Department of Justice and State Attorneys General global settlement with major mortgage servicers.” In the letter, which I obtained from an anti-foreclosure activist, Bank of America offered the homeowner full forgiveness of their entire home equity loan balance of over $177,000. But then Paragraph 5 came with an ominous warning: “Please be aware that we are required to report the amount of your cancelled principal debt to the Internal Revenue Service.”

Under current law, a principal reduction like this would be exempted from tax liability. However, that law, the Mortgage Forgiveness Debt Relief Act, expires at the end of the year, and after that, any mortgage debt forgiveness provided to a borrower will count as gross income for tax purposes, potentially costing millions of families several billion dollars. In the above case, the borrower would be required to pay taxes on the entire $177,000 amount forgiven by the bank, as if it were earned income. And that’s money that struggling homeowners simply don’t have.

“They wouldn’t be able to handle it,” said Peggy Mears of the Alliance of Californians for Community Empowerment, a community organizing group in California that has worked extensively on foreclosure issues. “If they could handle it, they wouldn’t be in arrears with their house notes. They don’t have that kind of money.”

The tax issue could significantly disrupt a still-fragile housing market and rob homeowners of the tools to pull themselves out of mortgage debt. It also represents a final indignity for homeowners who have been abused by the fraudulent mortgage practices of leading banks for years. Just when they think they get relief from their troubles, they get hit with a massive tax bill they cannot pay. “This has the effect of pulling people up with one hand, and hitting them in the face and knocking them over the cliff with the other,” said Sen. Jeff Merkley, D-Ore., who supports extending the law.

The issue dates back to 2007, when the housing bubble first started to deflate. Rep. Brad Miller, D-N.C., was tasked by the then-chairman of the House Financial Services Committee, Barney Frank , D-Mass., to find ways to help borrowers who would get caught up in the ensuing carnage. Miller’s search led him to Section 181 of the tax code. “I heard about the fact that interest reductions are not treated as income and principal reductions are, which creates a huge problem for modifying mortgages and solving the foreclosure crisis,” Miller said.

The odds of foreclosure largely correlate with a borrower’s level of indebtedness. A homeowner who’s “underwater,” meaning he or she owes more on the home than it’s worth, is far more likely to miss payments that a borrower with equity. And studies show that principal reductions do a far better job than any other kind of loan modification in helping borrowers maintain payments and avoid foreclosure. If you privilege other modifications through the tax code, like reducing the interest rate, over principal reductions, you punish those homeowners receiving the most sustainable type of modification, and eventually take them off the table, leading to a weaker housing recovery.

“I suggested to Barney [Frank] that we create an exemption for principal reductions,” Miller said. “Barney said to me, ‘Let’s go talk to Richie,’” meaning Richard Neal, the chairman of the tax-writing subcommittee in the House. Neal agreed to help, and the change.

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