When a mortgage goes bad the lender can often write off the loss as a tax deduction. But today, the North Carolina House is poised to pass a bill which would stick the homeowner with a hefty tax bill if all or part of their mortgage debt is forgiven.
First, some background. For a very long time any form of debt forgiveness was considered, in essence, income by the IRS. And the reasons are obvious. Imagine if a rich uncle gave you a loan for a million dollars and then generously forgave that debt. You’d still have a million bucks and Uncle Sam clearly wanted their piece of that action.
Then, in 2007 the housing market started to crater; some homeowners were stuck with huge mortgages they couldn’t afford. Foreclosures skyrocketed. Enter the 2007 Mortgage Forgiveness and Debt Relief Act. "It was a federal law that allowed homeowners who were doing short sales and getting debt forgiven by other means to not have that forgiven debt be taxable income," explains Daren Blomquist, senior vice president of Realtytrac which tracks real estate sales and foreclosures across the country.
When the law was passed lenders were getting hammered and something needed to be done. The law helped spur short sales, where homes were sold for less than the mortgage, after part of that debt was written off. "Many people were encouraging short sales," says Blomquist, since they were viewed as "a great solution to a problem of homeowners who have gotten in over their heads. But if they get this huge tax bill on top of that that’s really not helping them out at the end of the day."
Why a huge tax bill? Let’s say you had a $100,000 mortgage. You sold the house for $80,000 and the lender forgave the remaining $20,000. Without the tax break that $20,000 would be taxed as a lump sum payment, just like a bonus. Thus, a big tax bill.
Flash forward to today. The debt forgiveness act is still in effect on the federal level but the General Assembly now wants their piece of that pie. "The mortgage crisis of 2008, 2009, the short sales and the foreclosures from that, all those mortgages have been resolved by now." That's what Republican representative John Szoka of Cumberland County told the House Finance Committee on Tuesday. Szoka is a mortgage lender by trade. "What I am seeing people applying for credit now, if they have issues, it’s not from the mortgage crisis. It’s from decisions and local market conditions wherever they live that have happened since then."
Blomquist from Realtytrac agrees, the housing crisis is largely behind us. But there are still plenty of North Carolina homeowners this could affect. Those who are underwater, meaning they owe more on their mortgage than their house is worth. "In North Carolina, 10 percent of homeowners are underwater. Which is still a little bit high. But its below the national average of 11.5 percent. And if we look at Charlotte specifically, the percentage of underwater homeowners is at 8.8 percent."
A normal rate of underwater homeowners he adds is around 5 percent.
And there are other reasons homeowners can seek debt forgiveness like the loss of a job, bankruptcy due to, say, huge health care expenses.
There’s another aspect to this tax bill which affects far more homeowners. It would eliminate your ability to deduct interest paid on mortgage insurance, known commonly as PMI. "That’s a benefit that helps homeowners. It reduces their tax burden," says Al Ripley, Director of the Consumer and Housing Project at the NC Justice Center. "And if that happens in conjunction with having to pay this additional tax, than that is of course a concern as well."
A final vote on the bill is scheduled in the North Carolina House on Wednesday. It has already been passed by the Senate.