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.