Should Mortgage Debt Forgiveness be Taxed?

December 20, 2007

Today, President Bush signed into law a new tax law that puts in place a three year exclusion from income of mortgage debt forgiveness. Currently, individuals who receive forgiveness of their mortgage must claim the forgiveness as income on their IRS tax forms. This change in tax law is bad tax policy for two reasons. First, it’s temporary. If mortgage debt forgiveness should not be taxable income, then why should somebody who is in financial trouble in 2008 be more deserving of somebody who is in financial trouble in 2012? Such a provision defies logic and basically shows that the politicians are just trying to appease the short-run concern of voters, void of any true principle.

But then again, tax policy in Washington is rarely driven by principle. And that brings us to the second reason why this is bad tax policy mortgage debt forgiveness is income and should be taxed under an income tax. There is a reason that the IRS lawyers have ruled that this type of mortgage debt forgiveness should be treated as ordinary income.

Under a pure income tax, a house would be treated as an investment that pays annual dividends (in the form of imputed rental income) and which can have capital gains or losses which are realized upon sale. But for political reasons, we have decided that not only should imputed rental income not be taxed and capital gains on primary housing non taxed, but that homeowners should be able to deduct the mortgage interest that they pay. (It really is bizarre policy when you think about MID allowing people to deduct mortgage interest against income that they don’t have to claim.)

Now on the issue of debt forgiveness, if an individual seeks to purchase a $450,000 home and needs to borrow $450,000 to do so, the interest expenses should be deductible under the pure income tax assuming the imputed rental income is taxed. For simplicity, however, assume there was a zero percent interest rate. Suppose one year later, the value of the home now falls to $200,000 given the market and the bank forgives the remainder of the loan. $15,000 has been paid off, but the bank now forgives the person of the remaining $435,000 and takes the home. Should that $435,000 be taxed?

From a Haig-Simons perspective, the person’s change in net wealth is zero relative to the starting point (before the investment). Ignoring the imputed rental income (the consumption portion of HSI), the person would be forced to claim the forgiveness as income but also be allowed to deduct from income the huge capital loss as a result of the house depreciation. However, the U.S. tax system does not tax the capital gains from housing nor does it allow for housing-related capital losses to be deducted against income. Therefore, the forgiveness should still be treated as income and the person should have a positive tax liability.

Finally, it is worth noting that this will cost $1 billion. So how do we pay for that? Raise taxes on somebody else of course. Bloomberg News reports that “the $1 billion cost of the bill will be offset by raising penalties on partnerships and small businesses that fail to file tax returns.” That is not sound tax policy either. The penalties on partnerships and small businesses for not filing tax returns should be set in order to ensure proper compliance, and should not be increased merely because politicians want to raise revenue to pay for something else. (Same principle as Virginia drivers’ fees and cigarette taxes.) There is an optimal fine amount, which is independent of the need to raise money to help bailout homeowners who happen to be struggling when others are struggling.


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