Mortgage Forgiveness Plans Deserve Closer Look

Much focus has been placed on Treasury Secretary Henry Paulson’s misguided plan to bail out subprime ARM borrowers facing initial resets. But not much has been said about the “Mortgage Forgiveness Debt Relief Act” (H.R. 3648), which would eliminate the taxation of losses on foreclosed homes as ordinary income. Under the existing tax code, a homeowner whose home is foreclosed and sold at a loss is liable for income tax on the loss, presumably to offset the tax break the lender will get.

H.R. 3648, which passed the House by a 14-to-1 margin and now goes to the Senate, would eliminate that tax, retroactive to Jan. 1, 2007. Since that time, nearly 1.8-million foreclosure notices have been filed. Some of those are multiple filings, so the number of individual properties subject to foreclosure is smaller–data on that is not available prior to the third quarter; but it’s in the neighborhood of 1.25 million homes, based on the ratio of homes to notices filed for the third quarter.

A 2003 Fitch study found that the average loss rate was 41.2% in 2002. It’s undoubtedly higher now, given the above-average trend in real estate price appreciation since that time. Studies in the late 90s found the loss rate to be around 30%, providing further evidence that it’s rising. But let’s stick with 41.2% for now.

The median home price in the United States was $220,800 at the end of the third quarter, according to the National Association of Realtors. Let’s assume that the homes being foreclosed have no equity. Given the overwhelming volume of zero-down loans and the fact that home prices have fallen, that’s a fairly safe assumption–indeed, the popularity of 125% LTV and piggy-back loans, and the decline in prices, could well mean those homes have negative equity, but for now we’ll assume zero.

So, doing the math, if 1.25 million homes foreclose this year, resulting in at least a $91,000 loss on each (220,800 x 41.2%), that’s $113.75 billion in losses. At the 2005 average tax rate of 12.5% (which, again, may be higher for 2007, given income growth over the past two years), that’s a little more than $14.2 billion in foregone tax revenue–a bill that responsible homeowners will wind up footing.

Bear in mind, these are conservative estimates, based on past statistics. Today’s number could easily top $20 billion, and may be as high as $25 billion. And if H.R. 3648 gets extended beyond 2007, it will only become more expensive for all of us (no sunset provision is included).

Applauding the measure, an Orange County, Calif., real estate blog told the following sad tale: “Foreclosure is a terrible experience that ruins one’s credit for up to seven years. But to add insult to injury, if one purchased a home with zero down payment, and lost the home to foreclosure, and the home sold at the foreclosure sale for $50,000 less than the original sales price...the homeowner will possibly be subject to an additional $50,000 of taxable income...Ouch!”

Ouch, indeed. Buying a home with no money down that subsequently forecloses is a self-inflicted injury, if you ask us. And the ruination of one’s credit for seven years, plus the tax hit on the loss is a small price to pay for the privilege of paying cheap rent in the form of an ARM teaser rate for two to three years on a much nicer house than one would ever be able to legitimately afford.

Brian Hague, CFA, is President of CNBS, LLC. (c) 2007 The Credit Union Journal and SourceMedia, Inc. All Rights Reserved. http://www.cujournal.com http://www.sourcemedia.com