Pathways to avoid COD taxation. One primary source of COD tax avoidance is the Mortgage Forgiveness Debt Relief Act (MFDRA), which relieves COD taxation on debt forgiven on principal residences. Secondary loans on a primary residence also are exempt if forgiven, but only if the money from these loans was used to purchase or improve the property. Advocates should be ready to demonstrate that their client’s property was, in fact, used as a primary residence to qualify for the MFDRA’s relief.
Even if homeowners do not qualify under the MFDRA, some common law and statutory exemptions may provide relief. First, indebtedness discharged as part of a bankruptcy is exempt from COD taxation. Second, a purchase-price exception provides that when an original lender bargains with an original purchaser, a reduction in principal may be deemed an exception to COD income in cases of failing market conditions or reduced property values. Third, debts subject to a “bona fide” dispute over amounts due do not generate COD tax liability.
Anti-COD forgiveness arguments and their weaknesses. Some critics of the COD tax forgiveness embodied in the MFDRA argue that it spurs speculation on housing. This argument fails under scrutiny. First, it vastly overstates the extent to which the MFDRA benefits true speculators. Congressional relief applies only to principal home residences. Second, because Congress exempted only primary-residence indebtedness, the argument regarding unfair benefits to speculators would be valid only if homeowners receiving such forgiveness were hardcore capitalist speculators guilty of “rolling the dice.” Yet there is no evidence to suggest that the majority of homeowners at the height of the bubble sought to turn a quick speculative profit on their principal personal residences. Finally, arguments that COD taxation forgiveness spurs speculation suggest a sketchy proposition: namely, that people’s decisions to invest in primary residences are predicated on possible COD tax forgiveness.
Some COD tax forgiveness critics argue that it will encourage irresponsibility and defaults. Two rather obvious problems are present in this line of thinking. First, homeowner responsibility for repaying the loan is mitigated not only by the unprecedented market downturn but also by intentional and systematic market distortions such as overappraisals. Second, even if the forgiveness of COD income tax encouraged social or moral irresponsibility, that forgiveness only mimics the benevolence already shown to banks. Lastly, the MFDRA’s tax relief protected against some of the more irresponsible conduct of which some homeowners were guilty. The MFDRA did not excuse COD tax liability for any residence other than primary residences. Any specter of homeowners who bought four and five properties for a quick flip benefiting from the MFDRA is simply not in accordance with reality.
Critics also have attacked COD tax forgiveness such as that extended by the MFDRA as being disproportionately beneficial to the wealthy, both in terms of actual dollars and proportionately. Several glaring weaknesses exist in this argument. First, the justifications for COD tax exemptions are not income dependent. Society benefits when bankruptcies are prevented, when loan modifications are not disincentivized, and when barriers to settlements allowing homes reentering the market are removed. But these benefits do not accrue solely to middle and lower-class neighborhoods. Next, this criticism will never sway the opinions of those who believe that wealthy Americans already pay enough taxes or, contrarily, that they do not pay their fair share. Finally, it should be noted that the tax forgiveness extended by the MFDRA is not a zero-sum proposition. In other words, a wealthy homeowner does not steal a tax exclusion from someone else; rather, people benefit independently of whether others gain from the exclusion.
Lastly, anti-forgiveness critics claim that the MFDRA violates horizontal inequity—the need to treat equally situated taxpayers similarly—by excluding COD tax liability for forgiven mortgage debt only for certain years (from 2007 to 2013). Yet this dubious reasoning can be applied to any alteration in tax laws. Further, tax policy has long been influenced by temporary market conditions and has treated different types of borrowers differently.
The case for COD forgiveness. The most vital reason for granting COD tax forgiveness to homeowners is to disincentivize the filing of personal bankruptcies. Consider an average distressed homeowner whose property is $100,000 “underwater.” In a state that allows deficiency judgments, the homeowner could face not only the prospect of losing the home but also of being pursued for the $100,000 deficit between the outstanding loan balance and the value the property will fetch at auction or on the open market.
Now assume that the homeowner obtains an agreement from the loan servicer for a waiver of that deficiency in exchange for consent to a final foreclosure judgment allowing sale of the property without hindrance by court processes. In the absence of COD tax forgiveness, the $100,000 eventually would be reported by the lender as cancellation of debt. The homeowner would owe ordinary income tax on that amount in the coming tax year, which the homeowner estimates will be a sizable amount. The homeowner therefore has every incentive not to take the bank’s offer, to drag out the foreclosure process, and eventually to file bankruptcy. Significant loan modifications that spur COD taxation are likely to have similar negative consequences. Without COD tax forgiveness, certain homeowners may reject loan modifications or, alternatively, may risk re-default when the additional tax liability accompanying a modification strains the homeowner’s resources.
ABA Real Property, Trust & Estate Law Section
This article is an abridged and edited version of one that originally appeared on page 10 of Probate & Property, September/October 2013 (27:5).
For more information or to obtain a copy of the periodical in which the full article appears, please call the ABA Service Center at 800/285-2221.
PERIODICALS: Probate & Property, bimonthly magazine; Real Property, Trust and Estate Law Journal, published three times a year; e-Report, bimonthly e-newsletter.
CLE AND OTHER PROGRAMS: Watch out for RPTE’s monthly CLE teleconferences; for more information, please visit our website.
BOOKS AND OTHER RECENT PUBLICATIONS: The Advisor’s Guide to Life Insurance; The Commercial Lease Formbook, 2d ed.; The Insured Stock Purchase Agreement, with Sample Forms, 2d ed.; From Handshake to Closing: The Role of the Commercial Real Estate Lawyer, 2d ed.; Education Planning: Taxes, Trusts, and Techniques; Real Estate Opinion Letter Practice.