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Think Twice Before Extending Tax Break for Mortgage Relief

MAR 11, 2014 11:59am ET
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As Congress considers an extension to the Mortgage Forgiveness Debt Relief Act, the time is right to consider its potential unintended consequences.

The 2007 law allows homeowners to avoid paying taxes on discharged mortgage debt up to $2 million. It was passed to mitigate the tax consequences of loss mitigation and foreclosure techniques needed to help struggling homeowners with “underwater” mortgages, whereby home values are below the mortgage amount. The act played a key role in helping underwater homeowners keep their homes over the past six years, but it expired at the end of last year.

Normally, when a debt is canceled for forgiven, other than a gift or bequest, the cancelled amount must be declared as income and taxes paid on it. This tax liability is a major impediment to loss mitigation efforts that seek to reduce the burden of an underwater mortgage on a struggling homeowner. The MFDRA allows homeowners to avoid paying taxes on the discharged debt, opening many options for relieving the stress of homeownership in a bad housing market.

The problem is that the law leaves the door open for the forgiveness of debt to a new class of not-so-troubled homeowners often referred to as strategic defaulters. These are homeowners who default for financial gain, knowing their homes are underwater and that default can be used to improve their financial position.

The potential for strategic default remains high, even though home prices have improved over the past several years. The latest negative equity report from Zillow.com, for the fourth quarter of 2013, shows almost 20% of the mortgage market underwater, with many areas in California, Nevada, Arizona, and Florida still deeply underwater.

The MFDRA was established to help struggling homeowners, especially those with limited knowledge of their financial options. Strategic defaulters are, however, neither struggling nor naïve about financial matters. Interviews and blogs over the past several years show that they are sophisticated investors capable of carefully planning default. They may arrange to rent or buy another home prior to default while their credit is still strong. Knowing that their credit will suffer from the default, they may increase credit limits on old accounts or open new accounts prior to default. By the time they default they can afford to wait several years before returning to the credit markets. They may build a nest egg while living rent free during the foreclosure process. Older borrowers whose families have matured may conclude that they will never need significant credit again and the loss of credit is irrelevant.

Worried that you may not know all the ins-and-outs of strategic default?  A website, strategicdefault.org, advertises that it will help you “learn how to strategically default.” Or check out this 2011 article in Business Insider, “How To Strategically Default On Your Home And Live Scott-Free For Years.”

Strategic defaulters worsen the problems of declining housing markets. As prices drop the value of the strategy jumps and strategic defaulters aggressively unload their homes, increasing supply and depressing prices at the worst possible time for local markets. There is little incentive to maintain the home because it is fully expected to be returned to the bank at the last possible moment.

The $2 million limit in the MFDRA further increases the potential damage of strategic default by including nearly every mortgage in the U.S. This limit is far into the region known as the “super jumbo” mortgage market, where homeowners often own multiple homes and have sophisticated strategies for financial management. Is it reasonable to allow owners of multi-million dollar homes to have a tax break if they have the resources to make their payments but elect not to because they can gain from default in down markets?

Did the MFDRA unwittingly promote the use of strategic default? Strategic default was largely nonexistent before the housing crisis began in 2006 and 2007. By 2009 a study by Experian and Oliver Wyman estimated that one-fifth of the troubled mortgages involved strategic default. The cottage industry of websites, “how to” guides, and blogs aimed at helping people pursue strategic default was entirely developed in the past five years. While these points are anecdotal, it is at least safe to say that the MFDRA provided an environment conducive to the expansion of strategic default.

The need to renew the MFDRA was apparent in a letter last year from Boston Community Capital Chief Executive Elyse Cherry to Sen. Elizabeth Warren, D-Mass, suggesting that, absent the MFDRA, large tax bills are "not affordable to homeowners who are already struggling to make mortgage payments with limited income.”

The question Congress should consider is, “Are the tax bills affordable by homeowners who are not struggling and have the income to make their payments, but choose not to because they see a financial gain from strategic default?”

Peter Elmer is a senior advisor at Wall Street Emprises.

Comments (11)
Sorry, but the strategic defaulters all took the jump in 2008-2010, and many now have their credit cleared and ready to go. If you do not have the extension, we will have people further dragging out the foreclosures and then filing for BK's. This just limits the number of potential buyer in the 3-4 yr horizon.

Your argument, in my humble opinion is very shortsighted.
Posted by | Tuesday, March 11 2014 at 4:06PM ET
If you are unable to sell your home because its lost value you should be able to approach your bank and see if they will take the loss. You can't force people to stay in homes just based on value. If the banks can make decisions based on their analysis and get their money now versus 30 years from now which is an unknown the banks are still ahead. The only ones that lost were those that had the mortgage securization thinking they were A paper when they were barely D. Wall Street is allowed to speculate but the average homeowner has to stay put until the bank makes it's profit. A new style of indentured service where people stay because they won't do the "moral" thing and pay the mortgage.

When Wall Street gets some "morals" then the average person can feel guilty because they are looking out for their financial stability. With all the hidden insurance a lot of the investors had taken out on these "mortgages" I wonder how much they really lost???

We need MFDRA to continue to stabilize the market. I am not crying for any of these banks...notice how they are all closing their doors????
Posted by dynamicbroker | Tuesday, March 11 2014 at 4:10PM ET
Spoken like a true herder of sheep. There are thousands of homeowners whose lives would be destroyed by having to be shackled with 'relief of debt tax'. They have usually lost their jobs, finally lose their home, but thats not all folks!! Included in the fine deal is a GIGANTIC TAX BILL from which one probably cant recover. We all know the banking industry has been supported by the government yet you cry for them? Sure, some people probably did use it to make it easier to walk away but the numbers have to be much, much smaller than those who were/are really in financial trouble. How about a review of each case to determine who is abusing the system---or do you want to re-write all the rules regarding foreclosure, bankruptcy, etc? It wont hurt the banks if they do not issue 1099s on unpaid balances!!! For Gods sake. They dont need to do that for tax purposes.
Posted by | Tuesday, March 11 2014 at 4:30PM ET
In order to qualify for a short sale (discharged mortgage debt) you must provide all your income and asset documentation for the past 2 years. How then, is it possible to do a strategic default?
Posted by | Tuesday, March 11 2014 at 4:56PM ET
I agree with some of this but not in the case of short sales. They are a consensual act where the lender has to consent to the legitimacy of the hardship after full financial disclosure. Sure, there's some fraud in short sales but not meaningfully more than is found in institutional mortgages. If a lender agrees to do a short sale after full disclosure, thus recognizing the hardship after full disclosure and they got duped? . . . Then they should review their due diligence. In the meantime, slightly less than 1 in 5 are still upside down and the days of rapid appreciation are over. This is needed as much now as it has before.
Posted by Charles D | Tuesday, March 11 2014 at 5:35PM ET
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