Two days ago, for various reasons, I argued against any federal bail-outs for the housing loan industry in Yes, We Have No Bailouts
http://www.dailykos.com/... However, I did include some suggestions for what Congress could do to ease the emotional and financial pain for those who have lost or will lose their houses in this period. What I neglected to include in those suggestions was another very real and serious problem these people will face that could get much worse. One that I have no excuse for overlooking that is a component of debt forgiveness.
We already know that in some areas, house prices are inflated and some depreciation is likely. To what extent and how fast will depend on a number of factors. One of which is how many foreclosed properties are put on the market and the number of those that don't so quickly enough for the lender and therefore, must be auctioned off. Sale of real estate at auction in a soft market will usually be the lowest price that a real estate parcel can command. This means that the lender takes a loss. The difference between the balance on the loan and the net proceeds from the sale. Tough luck for the lenders. But, there is also a beneficiary of that loss. The people who lost their home. And that is a taxable gain for to them.
Let's use an example. Say Harry and Louise bought a house for $300,000 – no down payment and nifty low monthly payments for the first couple of years. They try but can't manage the reset interest rate payments. The lender forecloses. The house end up in an auction and sells for $150,000. That gives Harry and Louise a taxable $150,000 debt forgiveness gain. The tax on that, state and federal, could easily exceed $50,000. And remember bankruptcy even under the prior law did not wipe out IRS debt.
This is just beginning to surface:
After the Pain of Foreclosure, a Big Tax by Geraldine Fabrikant, NYT 8/20/07
http://www.nytimes.com/...
Two years ago, William Stout lost his home in Allentown, Pa., to foreclosure when he could no longer make the payments on his $106,000 mortgage. Wells Fargo offered the two-bedroom house for sale on the courthouse steps. No bidders came forward. So Wells Fargo bought it for $1, county records show.
Despite the setback, Mr. Stout was relieved that his debt was wiped clean and he could make a new start. He married and moved in with his wife, Denise.
But on July 9, they received a bill from the Internal Revenue Service for $34,603 in back taxes. The letter explained that the debt canceled by Wells Fargo upon foreclosure was subject to income taxes, as well as penalties and late fees. The couple had a month to challenge the charges.
Many of these people were first victimized by a predatory real estate sales operators and lenders. They have lost the home that they thought was theirs. And then the IRS, the government, moves in to victimize them again. Squeezing money out of people who have none. Yes, they made a poor purchase decision. One few of them would have made had they been fully informed, not encouraged to think big and not wanted to live a part of the American Dream. Congress absolutely must correct this injustice that hurts those who are already struggling.
Update: Final Note:
If you know anybody facing the prospect of foreclosure, advise them to maintain the house. Many of these properties are coming on the market in poor condition. Urge them to rise above the pain, hurt and anger and not trash the place. That will maximize what the house can be sold for and minimize their tax liability.