"Tax Nightmare" of Eminent Domain Mortgage Seizures

Gayle McLaughlin, mayor of Richmond, California is hell-bent on her plan to seize mortgages via eminent domain, then provide "mortgage forgiveness" for the homeowners.

I smacked the idea from a legal standpoint in Illegal Public Seizure of Mortgages Via Eminent Domain in the Spotlight.

Tax Nightmare

Legalities aside, there are also huge tax consequences to consider.

A local attorney and real estate broker posting under the name "davecherr" commented on the problem of debt forgiveness.

There is a massive and thus-far unremarked upon problem with this ED scheme: it would result in a MASSIVE INCOME TAX BILL FOR THE HOMEOWNER. Under the tax code, discharge of indebtedness is counted as income. There is a safe harbor for people who lose their primary residence to foreclosure, but it would not apply to these Richmond residents, since they would keep their house with magically reduced debt.

That debt reduction would NOT be tax-free. If a homeowner's mortgage goes from $400K to $190K under the proposed scheme, they would owe taxes on $210K of discharged debt (it would likely be much more, because all missed payments, late fees, and missed property tax and insurance payment, and interest on all of that, would be folded into principal -- such costs can easily drive principal from $400K to $500K over the course of 1-2 years of non-payment).

The federal taxes on that would be around $50K, and the state taxes $15K, for a total tax bill of $65K, or around $7K per year on a 15 year payment plan. As a local, I can tell you that most residents of Richmond do not have an extra $7K/year of income to pay such a bill. 

Who will tell the people of Richmond, and their craven politicians, that their scheme will lead to tax nightmares exploding all across their fair city?

Mortgage Forgiveness Act of 2007 Expires

Sure enough, "davecherr" is correct. Details can be found in the IRS publication Home Foreclosure and Debt Cancellation.

Update Dec. 11, 2008 — The Mortgage Forgiveness Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualify for this relief.

This provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion doesn’t apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.

1. What is Cancellation of Debt?

If you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes, depending on the circumstances. When you borrowed the money you were not required to include the loan proceeds in income because you had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount you received as loan proceeds is reportable as income because you no longer have an obligation to repay the lender. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.

2. Is Cancellation of Debt income always taxable?

Not always. There are some exceptions. The most common situations when cancellation of debt income is not taxable involve:

• Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
• Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your total assets. Insolvency can be fairly complex to determine and the assistance of a tax professional is recommended if you believe you qualify for this exception.
• Certain farm debts: If you incurred the debt directly in operation of a farm, more than half your income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, your cancelled debt is generally not considered taxable income. The rules applicable to farmers are complex and the assistance of a tax professional is recommended if you believe you qualify for this exception.
• Non-recourse loans: A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income. However, it may result in other tax consequences

Conclusions

It's safe to say this is not 2012. And even if the law was extended, there may still be huge tax consequences.

There is no bankruptcy, proving insolvency can be problematic, these are not farm debts, and the paragraph on non-recourse loans does not apply because there is no default.

The very purpose of the eminent domain seizure is to prevent default.

Bankrate has more on the insolvency issue in What does it mean to claim insolvency?

Q: Dear Tax Talk ...Can you explain what insolvency is? Is our 401(k) balance included in our assets? Thank you. -- Beverly

A: Dear Beverly, While your creditors may not have access to your retirement accounts, the IRS does. The general rule is that if you have a debt that is forgiven, you recognize income. Exceptions exist for primary home debt forgiven as well as debts forgiven in bankruptcy proceedings and when a taxpayer is insolvent.

The cancellation of your primary home debt is not considered income provided that the debt was used to purchase the home and was not increased by a cash-out refinance.

For many years, the tax law has given bankrupt and insolvent taxpayers a break when it comes to forgiven debt. It's pretty well established that if you enter into bankruptcy, certain assets, depending on your state of residency, are exempt from creditor claims. Generally, these assets are homestead property, insurance products and retirement accounts. What had not been clear is how these assets were treated in the case of insolvency; neither the law, IRS regulations, announcements or rulings explained it.

Prior to the real estate crisis, the IRS took a taxpayer's claim of insolvency to tax court. The taxpayers sought to exclude assets exempt from creditor's claims when measuring insolvency. The theory being that if the assets are exempt in bankruptcy proceedings, the taxpayer shouldn't be forced into bankruptcy just for the favorable tax consequences. The IRS and the U.S. Tax Court couldn't have disagreed more.

Hence, in determining the extent of your insolvency, you will have to count your 401(k) as an asset. I recommend you have your tax adviser work out the consequences more concisely so that you can measure the benefit of declaring bankruptcy.

For those who are not careful, this ill-conceived socialist wealth redistribution scheme of Mortgage Resolution Partners LLC will leave unsuspecting recipients with huge tax bills should it erroneously survive court challenges that are surely coming.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com