Good Intentions and Disparities

Last year I published an article in Public Integrity about the ethics of policy responses to the housing crisis and attempts to recover. I drew on my own experiences as a context-setting device. Read about the article here. Since writing that article in 2011 (published in 2012), more activity has occurred, which has continued to shed light on the challenges and equities of our housing recovery process, tax system, and inter-state fairness in those processes. Below is a brief update, again to set the context for my thinking, and then additional thoughts on policy innovations that can ensure a more just, fair, and equitable basis by which to effectively “share the pain” of such a housing market collapse.

An Update

In the published article, I talk about the property in Maryland (purchased in 2005 by my wife, before we were married) as being on the “brink of foreclosure.” In June 2011, it was foreclosed and sold at auction for $60,000 (owed on the property was approximately $250,000). This action came after a 2010 short sale offer that was rejected by the lender, and a 2011 short sale offer that was accepted but where the buyer then backed out. In 2012, we hired an attorney to negotiate settlement of the deficiency on two loans, one of which held my name. We successfully settled the one with both names, and the other is still sitting out there, despite efforts to reach a reasonable settlement (you might guess what side was not being reasonable–at least from my obviously biased perspective).

Come January 2013, and we get a 1099-C (Cancellation of Debt Income) notice from the bank that settled the debt, leaving “phantom income” of five digits pretty high up. If we are liable for tax on that income, it will cost us… let’s just say, more than we can write a single check for (or a multiple checks within a year or even two). There are options available through law, including protections for citizens who have incurred the debt on a “qualified principal residence” that maintained that status for 2 of the last 5 years, though there are possible exceptions (which we are counting on); alternatively, if the taxpayers can claim insolvency (debts outweigh the fair market value of assets), then there is no tax liability either. With the housing market what it is in Florida, we should have no problem claiming insolvency at least partially to reduce the taxable “phantom income.”

That’s the update, but here are a few things I’ve noticed as I have progressed from stomach-churning sadness to reasoned and rational resilience. First, we are liable for paying tax on cancelled debt because the property was in a state (Maryland) that allows for recourse, meaning the borrower is personally liable for the debt. Some states in the union are recourse states; others are non-recourse, meaning, in this case, if debt is forgiven, the borrower is not personally liable and thus the forgiven debt is not treated as income.

On the same theme, if I claim “insolvency” (debts outweigh fair market value of assets), in Florida I can claim the debt on my residence because Florida is also a recourse state. If I had moved to, say, California, the mortgage debt would be non-recourse, and thus I could not claim it as debt for which I am personally liable. So all in all–I lose in one state as a recourse state but gain in another…debt counts against me, and debt can help me. I wonder, though, what of the people who go from a recourse state to a non-recourse state, for similar career purposes as I have. They are pretty much out of luck!

Another observation: the rule to not be liable for cancellation of debt income is that the taxpayer must own and use a residence as a primary residence for 2 of the last 5 years. The rule is the same for taxpayers who wish to eliminate or limit tax they may owe on gain received from a sale of their house. Here’s why it doesn’t work for cancellation of debt income. The rule covers five years from the date the debt is forgiven, not the date on which the property was foreclosed or sold (which is the rule for gain on sale of house). The problem with this formulation is that there is no federal legal requirement for lenders to forgive debt within a certain period of time of a foreclosure. Thus, in our case, if the debt were forgiven on the day of the foreclosure auction, we would be firmly within that five years, but since nearly a year passed before that happened, the window shifted, and out we fell! By the time the other lender eventually forgives part or all of the remaining debt in my wife’s name, we will be not only out the window but lots of miles away.

The issue there is both a lack of a federal uniform policy but also a range of state-level policies that give lenders anywhere from 6 months to 3 years to file a “deficiency judgment” with the court. Thus, as with the recourse/non-recourse discrepancies, there are a wide array of discrepancies that ensure taxpayers are not given equal and fair treatment in assessing tax liability due to the peculiarities of state-level policy across the fifty states.

Policy Ideas

What can we do about this? As I suggested in my Public Integrity article, I believe it is within the jurisdiction of the federal government to establish nation-wide standards, at least when it comes to debt that is recourse/non-recourse for treatment by the federal tax code. States can continue to have their preference for how to treat such “phantom income” as it arises, but there needs to be a universal policy across the fifty states when it comes to paying federal taxes.

Likewise, it seems sensible to take a “2 in 5 rule” that is in use in another part of the tax code and apply it to the exclusion of foreclosure related cancellation of debt income, but given the array of state requirements to which lenders must abide, the rule does not transfer cleanly. Indeed, it creates discrepancies. The federal government must pass a policy that more equitably and fairly addresses this issue. For instance, the rule can say “2 in 5 years” from the date of the foreclosure or short sale certification, rather than the date of the debt cancellation. This would eliminate a big chunk of uncertainty.

Overall: Good Intentions Do Not Pay–They May Cost

Throughout this process, my wife and I tried to act with good intention. When first leaving Maryland for my new employment in Florida, we tried to sell the house. This was just when the market started to visibly crumble. Once clearly not successful and unaware of the depth and longevity of the housing crisis we would endure, we tried to rent it, thinking to do so for 2-3 years would give time for market recovery or at least stabilization. Over two years, we rented to three tenants–the first of whom moved in and out before the start of the actual lease (we thought we were being kind). None of the rents collected covered the mortgage, and the house deteriorated in condition. As a new assistant professor getting established in a new community, we didn’t have the resources to repair the home (estimated costs of $30,000, combined with the horribly under water status of the property). We attempted the short sale, earnestly. We pleaded with the mortgage company to give us more time to get a sale; when the first offer received was rejected, we pleaded for more time (thinking a short sale gives us more control over whether the lenders would forgive the debt versus pursuing deficiency). The second offer came in, and the buyer asked to moved in rent-free to make some repairs to qualify for a VA loan. We agreed. The buyer backed out.

Throughout this time, pipes froze and burst, copper pipes were stolen, mold developed. All kinds of stuff.

My cynical lessons: we should have done none of it. If we had not pleaded for more time to get a short sale, we could have been free and clear. If we more aggressively pursued the buyer who walked out, we could have been more or less free and clear (minus attorney’s fees for more aggressively going after the buyer). If we didn’t care about giving people a “chance” despite bad credit reports to rent the house, we could have potentially kept it in better shape. If we simply walked away in 2007, . . . I probably would not be writing this blog now and probably would not have published the article in Public Integrity. I hate every moment of this experience but consider myself more informed, more empathetic, and more certain of laws and rules that need to change. If I don’t act on my experience to improve the situation for the poor souls who follow a similar path to mine ten years, fifty years, or one hundred years from now, then all of this is for nothing.

Do you agree with my policy proposals? Share them with your elected representatives. Do you disagree? Help me improve them.

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