Even as it continues to improve, the specter of negative equity—those homeowners that are underwater on their mortgage, owing more to the bank than their home is worth—will act as an anchor on the housing market for years to come. But rather than acting to help ease the problem, congressional inaction is instead keeping a lifeline away from drowning homeowners.
As of the end of the second quarter, 17% of Americans with a mortgage were underwater. That’s down from 18.8% in the first quarter and 23.8% in the second quarter of last year, which is real progress. But when almost $9 million homeowners with a mortgage nationwide still can’t or won’t realistically enter the market because they’re underwater, the pool of eligible buyers and sellers shrinks, sales volume falls and inventory gets tighter.
At best, high negative equity leads to a decrease in mobility—more people simply stay put in their homes, stuck underwater or unable to find a home they can afford. At worst, it leads to higher foreclosure activity, as desperate homeowners default on loans that are increasingly burdensome, or simply choose to walk away from homes that are too far underwater.
But, at least in recent years, there have been other options. Under the federal Home Affordable Modification Program (HAMP), homeowners worked with their lenders to reduce the amount owed on their mortgages through a reduction in principal, enabling millions to stay in their homes at more favorable terms, even if they remained underwater.
Many underwater homeowners have also considered a short sale, working with their lender to solicit offers for their home that were less than the outstanding loan amount, but still acceptable. In many cases, short sales allowed lenders to recover more money than if they had allowed the home to proceed through the often lengthy and costly foreclosure process.
But as of Jan. 1, loan modifications and short sales, generally the most effective cures for negative equity—short of time itself—no longer represent the comparative bargain they once were. Beginning in 2007 and continuing through 2013, the Mortgage Forgiveness Debt Relief Act waived federal tax rules that otherwise would have counted forgiven debt (foreclosures, short sales, and loan modifications that include principal forgiveness) as taxable income. But Congress has so far failed to reauthorize the debt relief act for this year, choking off a potential outlet for underwater borrowers.
Without this waiver, if a lender forgave, say, $20,000 in debt, a borrower would then have to pay taxes on that debt as ordinary income. For borrowers in the 25% tax bracket, this represents $5,000 they’d need to pay out of pocket.
Opponents of reauthorization argue that the perpetually cash-strapped federal government is giving up too much money by forgiving billions of dollars in taxable “income.” Estimates on lost federal revenue range from roughly $2.6 billion over two years to more than $6 billion, according to a recent study by the Urban Institute.
That’s real money, but the costs of not reauthorizing the act could be much, much higher.
Underwater homeowners should always evaluate all of their options before defaulting, because walking away from a deeply underwater home has terrible economic consequences, including ruined credit and an inability to buy another home again for a number of years. But, absent debt relief provisions, those options are now—unnecessarily—much more limited.
There are also some profoundly unfair aspects of taxing debt relief. When homeowners sell a home after it has increased in value, the capital gain received is generally not taxed. So, Uncle Sam doesn’t care about collecting revenue from rising home prices, but does want in on the action when home prices fall. What’s the public policy rationale of that? Second, if you live in states with non-recourse home loans (e.g., California), you are not subject to the debt forgiveness tax at all. Does it really make sense that our treatment of debt forgiveness be the result of some geographic roulette game?
Negative equity is bad enough on its own, and has gummed up the housing markets for far too long. We need to do everything we can to get back to normal as quickly as possible. Reauthorizing the Mortgage Forgiveness Debt Relief Act, in this sense, is a no-brainer. And it’s not too late for Congress to act. Any reauthorization before the end of this year could easily be made retroactive to Jan. 1, effectively ending this entire debate and allowing short sales and loan modifications to be pursued as the effective solutions they are.