As a result of financial hardship or a decline in property values, many homeowners under threat of foreclosure opt to attempt a short sale or a deed-in-lieu-of-foreclosure settlement to escape liability for a potential deficiency between the selling price of the distressed property and the amount owed on the original loan. For federal income tax purposes, such a cancellation of indebtedness (COD), if granted by a bank or lender, is generally considered ordinary income. See Internal Revenue Code § 61(a)(12) (“gross income means all income from whatever source derived, including . . . [i]ncome from discharge of indebtedness”). Thus, many distressed homeowners face the risk of not only losing their homes but also owing thousands of dollars in income taxes. Homeowners’ advocates must therefore be aware of the possibility of such taxation and of the opportunities to avoid it. Furthermore, those advocating for pro-homeowner legislation should be aware of the arguments for forgiveness of such taxation and of the weaknesses in arguments against forgiveness.
This article describes contexts in which COD tax liability arises, explains how such liability can be avoided, and analyzes policy implications of such liability. For further discussions of this topic, see the author’s study in the Arkansas Law Review, published as part of the 2013 Arkansas Law Review Symposium: Lessons Learned from the Mortgage Foreclosure Crisis. Dustin A. Zacks,Avoiding Insult to Injury: Extending and Expanding Cancellation of Indebtedness Income Tax Exemptions for Homeowners, 66 Ark. L. Rev. 317 (2013). See also Joseph C. Mandarino, The Tax Effects of Debt Cancellation—A Primer for Non-Tax Lawyers, Prob. & Prop. Mar./Apr. 2010, at 20, 21.
When Does COD Taxation Arise?
COD taxation can arise in the arenas of foreclosure or distressed properties in a number of ways.
First, when homeowners seek to keep their homes with modified loan terms, such modifications traditionally have been treated as COD income if the modifications are deemed significant. See Treas. Reg. §§ 1.1001-1(a) & 1.1001-3(b). Significant modifications include a change in the interest rate of at least 25 basis points or a 5% change in the annual yield. Id. § 1.1001-3(e)(2)(ii)(A), (B). Joseph C. Mandarino, The Tax Effects of Debt Cancellation—A Primer for Non-Tax Lawyers, 24 Prob. & Prop. 20, 21, Mar./Apr. 2010.
Second, homeowners unwilling or unable to modify their loans may seek short sales or deeds in lieu of foreclosure, which also have generated COD taxation discussions. In such scenarios, homeowners bargain for a settlement in which a lender accepts less than the full amount owed in return for a sale to a third party or for the relinquishment of the deed. In return for generating such a sale or for recovering the property in acceptable condition, lenders often waive their right to collect the deficiency, the difference between the amount owed on the original loan and the amount actually realized through a short sale or a foreclosure auction. The forgiveness of the deficiency owed is a classic example of COD income and normally would generate tax liability at ordinary income rates.
Many lenders have been keen to forgive potential deficiencies in exchange for a short sale or deed-in-lieu settlement. Through such settlements, lenders avoid a drawn-out foreclosure process and the further risk of deterioration of the property. For homeowners, such settlements are an optimal pathway to avoid liability and evade the necessity of a bankruptcy to avoid a lender pursuing a deficiency judgment in states where such a remedy exists.
Unfortunately, homeowners using waivers of deficiencies face a Hobson’s choice: they can declare bankruptcy, costing a few thousand dollars in attorney’s fees and discharge personal liability; or they can settle with their lender and face many more thousands of dollars of tax liability from COD income taxed at ordinary income rates. Worse yet, these homeowners are essentially being taxed on phantom income—income they never saw line their pockets. Thus, advocates representing homeowners must be able to advise clients about the ways to avoid such taxation.
Pathways to Avoid COD Taxation
One primary source of COD tax avoidance is the Mortgage Forgiveness Debt Relief Act of 2007 (MFDRA), Pub. L. No. 110-142, 121 Stat. 1803, which has been extended to cover debt forgiven through 2013. This statute 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 those loans was used to purchase or improve the property. Home equity lines of credit used to pay medical bills or credit card debts, for example, are not eligible for COD tax exemptions if waived by a bank or lender.
Investment and secondary property loans are not eligible for COD tax avoidance. Thus, 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.
Next, even if homeowners do not qualify for COD relief under the MFDRA, some common law and statutory exemptions may provide relief that is worth exploring. First, indebtedness discharged as part of a bankruptcy is exempt from COD taxation. See IRC § 108(a)(1)(A). For the reasons discussed elsewhere in this article, however, bankruptcy is not always the best option. 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. See IRC § 108(e)(5). Third, debts subject to a “bona fide” dispute over amounts due do not generate COD income tax liability. Martin J. McMahon Jr. & Daniel L. Simmons, A Field Guide to Cancellation of Debt Income, 63 Tax Law. 415, 435–39 (2010).
Some borrowers also may consider the insolvency exception codified in IRC § 108(a)(1)(B). But the insolvency exception may be an unsatisfactory remedy because it acts only as a deferral of COD income tax liability. Curt Hochbein, Comment, Mortgage Forgiveness Debt Relief Act of 2007, 38 Cap. U. L. Rev. 889, at 916–17 (2010). Accordingly, even insolvent homeowners may eventually owe taxes on COD income. In addition, the insolvency exception’s calculation of assets and liabilities mandates that taxpayers take their bankruptcy-exempt assets into account, including retirement savings. Statement of Deborah A. Geier, The Housing Decline: The Extent of the Problem and Potential Remedies: Hearing on H.R. 3648 Before the S. Comm. on Fin., 110th Cong. 6 (2007), available at www.finance.senate.gov/imo/media/doc/121307testdg.pdf.
Besides being able to effectively explain the consequences of cancellation of home loan indebtedness and the ways to avoid COD taxation, attorneys advocating for pro-homeowner legislation such as the MFDRA should be aware of the many arguments against such tax forgiveness as legislative debates on this issue are sure to continue. Such debates increased in importance in the “fiscal cliff” debates of late 2012, in which the MFDRA’s exemptions were set to expire at the end of 2012.
Anti-COD Forgiveness Arguments and Their Weaknesses
COD Tax Forgiveness Spurs Speculation
Some critics of the COD tax forgiveness embodied in the MFDRA argued that it spurs speculation on housing. See, e.g., Bradford P. Anderson, Robbing Peter to Pay for Paul’s Residential Real Estate Speculation: The Injustice of Not Taxing Forgiven Mortgage Debt, 36 Seton Hall Legis. J. 1, 25 (2011). 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. See IRC § 108(a)(1)(E), (h)(5). Thus, the most irresponsible, speculative indebtedness—arising from people investing in second, third, or fourth homes for a quick speculative “flip”—will not be forgiven under the MFDRA.
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 Anderson presents no evidence to suggest that some majority of homeowners at the height of the bubble sought to turn a quick speculative profit on their principal personal residences. His argument suggests that any family investing in a home hoping for eventual positive returns is as crazy as a penny stock investor or a roulette wheel gambler.
It is far more realistic to expect that homeowners rationally sought a safe investment that would yield a positive return over time. Given that housing prices took 70 years to decline at historically significant rates, investing in a primary residence, even during periods of high price appreciation, can hardly be equated to rolling the dice. Little evidence exists, therefore, to suggest that most homeowners obtaining COD tax forgiveness were short-term flippers or speculators.
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. In light of behavioral science research that indicates that humans do not expect bad things to happen, it is unconvincing to suggest that the MFDRA will encourage people on the sidelines of the real estate market to jump into real estate investment.
COD Tax Forgiveness Spurs Irresponsibility
Some COD tax forgiveness critics argue that COD forgiveness will encourage irresponsibility and defaults. Two rather obvious problems are present in this line of thinking.
First, homeowner responsibility or the morality of repaying one’s loan is mitigated not only by the unprecedented market downturn but also by intentional and systematic distortions. Consider, for example, the systematic overappraisals, discriminatory lending behavior toward minorities, and vast variety of predatory conduct present at the height of the bubble. In light of the active perpetration of overappraisals and the peddling of unnecessarily risky or high cost home loans, some mitigation of the duty to repay, much less to pay taxation on sums forgiven, is surely called for.
Second, even if the forgiveness of COD income tax encouraged social or moral irresponsibility, that forgiveness only mimics the benevolence already shown to banks. If tax relief for distressed homeowners excuses a small portion of homeowners who speculated and are now strategically defaulting (choosing to default even though able to pay, an arguably irresponsible or immoral action to some), that tax relief still constitutes only a small portion of the tax relief afforded to homeowners when compared to the mortgage interest tax deduction, and it certainly pales in comparison to the billions of dollars of bailout money provided to banks. The problem of homeowners escaping some tax liability certainly seems pedestrian in light of such bailouts.
Lastly, the MFDRA’s tax relief protected against some of the more irresponsible conduct of which some homeowners were guilty. It bears repeating that 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, therefore, is simply not in accordance with reality.
Forgiveness Unfairly Benefits the Wealthy
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. See, e.g., Anderson, supra, at 14–15. 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. What is clear, however, is that MFDRA tax forgiveness is unlikely to increase or decrease the percentage of overall income taxes that wealthy Americans pay. Thus, this argument is essentially an argument against ever cutting taxes for the upper classes—an argument that can be made in any context, but which does not have any specific or relevant application to the MFDRA’s tax forgiveness.
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. The argument that COD tax forgiveness unfairly benefits the wealthy is, therefore, also unconvincing.
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). See Anderson, supra, at 16–18. 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. Such a criticism, again, fails to effectively rebut the positive effects of COD tax forgiveness, discussed below.
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”—that is, the homeowner’s loan is for $200,000 but the property is only worth $100,000. Hence, in a state that allows deficiency judgments, the distressed 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 distressed 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 on a 1099 form as cancellation of debt. The homeowner will owe ordinary income tax on that amount in the coming tax year, which the homeowner estimates will be a sizable amount.
In the face of such a sizable tax liability, the homeowner has every incentive not to take the bank’s offer, to drag out the foreclosure process, and to eventually file bankruptcy. The few thousand dollars the homeowner will face in attorney’s fees for filing bankruptcy pale in comparison to the amount of taxes faced in the absence of COD tax forgiveness.
It is beyond the scope of this article to examine the entire number of ways in which preventing bankruptcies benefits individuals and society alike. But it bears emphasis that individuals face lifetime credit consequences from filing bankruptcies, and society faces increased costs and externalities when individuals stall the foreclosure process only to file bankruptcy.
Avoiding Disincentives to Loan Modification
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 redefault when the additional tax liability that accompanies a modification strains the homeowner’s resources.
Hastening the Recovery of the Housing Market
Tax forgiveness may hasten the recovery of the housing market in a few different ways. Again, incentivizing homeowners to avoid a quick and orderly surrender of their properties could result in a longer foreclosure process. Lengthening the foreclosure process has been linked to a few negative externalities including, first, the risk that properties under threat of foreclosure will deteriorate and spur surrounding home values to decline and, second, that future loans will become more expensive as lenders price in the risk of a more expensive foreclosure process. See Dustin A. Zacks, The Grand Bargain: Pro-Borrower Responses to the Housing Crisis and Implications for Future Lending and Homeownership, 57 Loy. L. Rev. 541 (2012). Making the process of surrendering properties easier avoids the incentives that could make these risks a reality.
The Purchase Price Exception and Grounds for Expansion
Although the “fiscal cliff” discussions contemplated only whether the MFDRA would be expanded for another period of time, legislators, for the reasons stated above, should consider the expansion of one of the existing measures of relief for COD taxation: the purchase price exception. This judicially created exception first appeared in Hirsch v. Commissioner, 115 F.2d 656 (7th Cir. 1940), where the court characterized the forgiveness of a portion of the debt as a reduction in the purchase price, rather than taxable income.
Viewing the realistic picture as a whole we see that [the debtor] purchased the property for $29,000, $19,000 of which was to be paid in the future. Then came the depression; the value of his purchased asset shrunk to $8,000. It was not yet fully paid for; it was not worth paying for; it could not be sold for enough to satisfy the balance remaining unpaid on the purchase price. Caught in this dilemma he negotiated for and secured a reduction of $7,000. True, this was a forgiveness of indebtedness, but, more than that, it was in its essence a reduction in purchase price from $29,000 to $22,000. As the facts stand petitioner has paid $22,000 for certain property which he still owns and he is, therefore, unable to determine whether he has had a gain or a loss. If he should sell the property for $8,000, its present value, he will have lost the difference between $22,000 and $8,000; if he should sell for more than $22,000 the excess will represent gain. But his ultimate gain or loss can not be determined until liquidation of his capital investment.
Id. at 658.
Curiously, this, sounds nearly exactly like the situation of a homeowner who might receive a principal reduction as part of a loan modification. Yet, the peculiar history of the purchase price exception does not apply for most distressed homeowners today, for the mere fact that the statutory exception only applies when the original lender is still a party to the modification or settlement. See IRC § 108(e)(5). Thus, the vast majority of distressed homeowners are at risk of COD taxation if they attempt to reach a settlement that forgives liability, merely because their loan has been sold on the secondary market.
The incongruity between this tax treatment and other areas of the law has been remarked on by commentators. Consider, for example, that in most debtor-creditor situations, the debtor may assert any defense against a subsequent creditor. Yet here, the fact that a creditor has transferred the rights in the loan to another party disadvantages the homeowner through no act of his own doing.
The Hirsch court was on the right track when it discussed a reduced property value situation and stated, rather intuitively, that “[t]o say that anything of value has moved to [the debtor] is contrary to fact.” Hirsch, 115 F.2d at 657. In light of the rampant overappraisals given at the height of the housing bubble, no serious commentator can suggest that homeowners surrendering their properties in lieu of contesting a foreclosure are net winners deserving of taxation. The phantom income they face taxes on has not been spent, has not been enjoyed, and will not be recouped. Making them pay taxes on what has been a net loss (after a down payment on a home, making payments for years and paying property taxes, insurance, and upkeep) is not only counterintuitive, but it also disadvantages those who urgently need to start with a clean slate—not with a sizable tax bill.