Mortgage Forgiveness Act: The Seen and the Unseen

by: Michael Shedlock

Inquiring minds have been asking me about H.R. 3648, the Mortgage Forgiveness Debt Relief Act of 2007.

Families dealing with the pain of a foreclosure should not have the double whammy of a large tax bill for terminating their mortgage through no fault of their own," said Ways and Means Committee Chairman Charles B. Rangel. I am pleased the Committee joined together to unanimously pass this critical legislation and I look forward to bringing this measure before the full House."
Details of the Bill

Here is the H.R. 3648 Summary of Legislation.
My notes on the legislation follow:

1) The legislation would provide relief to those families by permanently excluding debt forgiven under these circumstances from tax liability. Prior to this legislation, forgiven debts were added to a person's tax liabilities as ordinary income. For example, if a person walked away from a home owing $100,000 more on a house than the foreclosure sale proceeds and that debt was forgiven by the lender, the IRS considered that $100,000 as ordinary income and expected taxes to be paid on the amount of forgiveness. This proposal is estimated to cost $1.379 billion over 10 years.

2) The bill extends the deduction for private mortgage insurance for seven years. This proposal is estimated to cost $570 million over the next 10 years.

3) Two alternatives will make it easier to qualify as a cooperative housing corporation. This proposal is estimated to cost $22 million over 10 years.

4) The bill amends the current law exclusion of up to $250,000 ($500,000 if married filing a joint return) of gain realized on the sale or exchange of a principal residence. Under current law, the sale of a home will qualify for this exclusion if the home is a taxpayer’s principal residence for at least two of the five years ending on the sale or exchange. This exclusion applies even if the home was initially purchased as a second home. Under the bill, if a taxpayer moves their principal residence to a second home, the taxpayer will only be able to utilize this exclusion to the extent that it relates to the period of time when the home was first used as a principal residence. The bill grandfathers use before 2008. This proposal is estimated to raise $2.005 billion over 10 years.


Support For The Bill

Letters of support for H.R. 3648

The National Association of Homebuilders (NAHB) chief lobbyist Joseph M. Stanton sent a letter of support on behalf of the more than 235,000 members of the NAHB to the Chairman and Ranking Member of the Committee on Ways and Means. The Mortgage Bankers Association and the National Association of Realtors (NAR) did the same. See the above link for the respective letters.

Winners and Losers - Seen And Unseen Analysis

The bill is almost revenue neutral, adding $34 million to government revenues (assuming one believes the cost estimates) . Let's take a look at the winners and losers of this bill as well as the unseen consequences of the legislation.

1A) The winner in the debt forgiveness provision (if there is a winner) is the struggling homeowner. The unseen loser is the mortgage holder, the NAR and the NAHB. Prior to this legislation a homeowner had to worry about tax liabilities of just handing over the keys and walking away. If debt was forgiven prior to bankruptcy, there was also a tax liability. Such considerations have been removed. At the margin, more people will be tempted than before to hand over the keys and walk away.

If instead, banks start forgiving bad debt in advance just to stave off foreclosures, margins will suffer and it will encourage more people to actively seek debt relief, up to and including purposely not paying bills. Certainly anyone with a grudge against either a builder or a lender may just decide to "make things fair" (in their eyes of course).

The seen supposedly keeps people in their homes. The unseen questions the merit of keeping people in their homes at any cost, as well as the likelihood that the measure actually works as intended in the first place. Besides, many of those in trouble have had their loans securitized, packaged, and further sliced and diced. It may be hard to get the right parties to the table to forgive the debt. Handing over the keys forces that issue.

If more people do walk away, inventories will rise and home prices will fall in response. Looking still further ahead, if debt is not forgiven after people walk away and lenders start hounding the prior homeowner for payment, the prior homeowner will seek relief via bankruptcy. Given that there is a means test on bankruptcies because of the Bankruptcy reform act of 2005, those seeking bankruptcy will be encouraged to find a way to meet the means test.


The debt forgiveness provision of this bill has the ability to cascade into all sorts of things mortgage holders would not want to see. Specifically, any housing relief measure that rewards bad behavior (not paying the mortgage or handing over the keys) is likely to fail miserably. For more on this topic, please see Mr. Practical's take on the Countrywide Mortgage Restructure Free-For-All.

2A) The homeowner and the various sponsors of the PMI deduction are winners of this provision at the expense of non home owners and other taxpayers of course. Such unfair tax promotion of housing is one of the problems that helped create the mess we are in.

3A) I do not know enough to comment on cooperative housing, but the perceived benefit seems to be very small, at least at the moment. Nonetheless, the provision is there for a reason. Someone thinks they will gain by it.

4A) The principle residence exclusion is the most interesting provision in the bill. Previously, homeowners could play the "moving game" and reap huge tax gains on multiple properties. The retroactive closing of this loophole discourages moving for tax purposes and it discourages buying second homes as a tax shelter in the first place. The most important point is the retroactive nature of the provision regarding the first use of the home as a primary residence.

From the point of view of the NAHB the negatives should be obvious. There will be reduced desire to build new homes attempting to take advantage of tax shelters.

From the point of view of the NAR, there will be fewer tax avoidance transactions in future years. Fewer transactions means less commissions. A small positive is that it might on balance (in future years) reduce inventory. But there also could be a mad dash by motivated sellers right now, all attempting to take advantage of the tax loophole before this bill is signed into law. If so, additional inventory could be coming on to the market right now as I type, when home inventories are already soaring.

What's Fair?


The bill is arguably far more fair than before. That's actually surprising. But what really needs to happen is that Congress should scrap virtually every existing tax law in entirety, eliminate the IRS, reign in government spending, reduce the role of government in our lives, and start all over with a simple flat tax, consumption tax, or combination thereof.

Instead of doing what right, more and more legislation is piled on top of existing legislation. And as you can see from the tangled web of unseen consequences above, Congress will no doubt be back amending and re-amending this very bill in years to come on behalf of lobbyists who did not foresee the consequences of the bill as it was written today.