A Huge (and Unfair) Tax Bill on Top of Foreclosure
A story in this morning's New York Times shows another consequence of the foreclosure crisis: a huge tax bill for those losing their homes. When a home is foreclosed on borrowers whose mortgage exceeds their home value, the difference is considered "cancellation of debt" income. Consequently, the borrower must pay full income tax on it. This could be a huge bill because borrowers will owe the IRS up to 35% of the difference. Congress fixed the problem for those whose mortgages are secured by the homes they live in under the Mortgage Forgiveness Debt Relief Act, which is effective from Jan. 1, 2007, through Dec. 31, 2009. But this act does not apply to those facing foreclosure on second homes. This tax is affecting many middle-class borrowers and pushing many into bankruptcy. But it is unfair and inconsistent with fundamental tax principles.
The decline in value should just be considered a "capital loss," rather than income. The reason that cancellation of debt counts as income is that the Code assumes that debt is used to finance consumption. So if I borrow $100 to buy new shoes, and you pay it back for me, I would essentially have bought the shoes tax-free unless repayment of the loan constituted income. (I wouldn't pay tax on the $100 when I take out the loan.) More analogously, if I buy a car and drive it for five years, the resale value will be lower because of my consumption. In this situation, though, the decline in value is not due to the borrower's use of the house but to changes in interest rates and the market--which means it's like an investment and should be treated under capital gains and losses. In that situation, $3000 of capital losses could offset ordinary income, and the rest could be used to offset any realized capital gains (so they would be "unused" if the borrower doesn't have much of a portfolio).
Indeed, many borrowers purchased these houses explicitly as investments. One couple in the Times story makes $65,000 a year. They bought a second home on investment advice, hoping to rent it out until they could sell it to pay for their children's college education. What strikes me as unfair is that both Democratic candidates are committed to maintaining the capital gains preference in some form (even though the justifications for it are flimsy and it benefits mainly the wealthy), and prominent Democrats like Senator Chuck Schumer have equivocated on taxing the earnings of hedge fund managers as ordinary income. (Not to mention that Social Security taxes are still only paid on the first $90,000 of income and that Democrats do not uniformly support lifting that cap.) This foreclosure tax should be fixed on all homes so that Treasury no longer bilks middle-class borrowers into bankruptcy while hedge fund managers party on paying 15%.
How is a second house anything but consumption or investment?
This article is hopelessly muddled. A few basic facts might clarify things:
The loan and the house are two different things from a tax perspective.
Money borrowed (a loan) is not taxable as long as it's paid back. If it's not paid back, it is considered income and taxed just like any other income. When a mortgage is forgiven, the principal not paid back is considered, like any other unpaid debt, income and taxed accordingly. No big inconsistency between mortgages and any other type of debt here--except that Congress has now allowed a temporary exemption from the income tax if the forgiven loan was used to purchase a primary residence. In addition, non-recourse mortgages (where the lender agrees to accept the value of the house as full payment of the mortgage in a foreclosure, even if the value of the house is less than the amount owed) are not considered forgiven debt when paid off through foreclosure and therefore result in no income tax.
From a tax perspective, the house itself is a separate thing. It is purchased property that can increase or decrease in value. Where the money came from to purchase the house (a loan or your savings) doesn't matter from a tax perspective. All that matters is whether the value of the house at sale is higher or lower than the value at purchase. The difference in value between purchase and sale is either a capital gain or a capital loss. If it's a gain it's taxed at capital gains rates. In a foreclosure there's usually a loss, however. Under current tax law, you can't take a capital loss deduction for a loss on the sale of your residence, but you can take a capital loss if you purchased the house as rental or investment property. Maybe capital losses should be allowed on sales of residences, but even if they were, the tax benefit to people whose homes are foreclosed upon would be small because capital losses only offset capital gains, and most of the folks in foreclosure don't have a lot of capital gains to offset I suspect. Of course, we're talking about investment properties here, so the capital loss is allowed in these cases anyway.
Now on to the point of the article. The author seems to be suggesting that taxes on unpaid debt should be forgiven if the debt was used to purchase a home--even if the home was used not as a residence but as a rental or investment property. I simply don't understand why a loan to purchase a house for investment purposes should be treated any differently from a loan to purchase stock for investment purposes or a loan to start one's own business for investment purposes. In fact, the couple who took a loan to buy rental property were essentially using debt to invest in a business venture. This isn't ordinary saving for college (leveraged investment isn't how most people save for college is it?). They took a high-risk strategy and their strategy failed. Why, though, should they get treated specially and have the taxes forgiven on the loan they took and didn't pay back? No other investor would get such a break. Now I guess you could make an argument that all forgiven debt shouldn't be subject to income taxes (that would be consistent treatment), but then people who fail to pay back loans would get money tax free while ordinary Joe Blows who work for their money would pay taxes on it. Is this fair? I don't think so.
I think we should do things to help poor people who are losing modest primary residences because of financial difficulties or exploitive loans they took. But why should we start bailing out middle class investors purchasing second homes? That's going too far in my mind. Sometimes, people have to suffer the consequences of their stupid or greedy decisions.
May 30, 2008 8:12 AM | Reply | Permalink
Oh my god . . . I read the NYT article after making my comment. It's worse than I thought. The couple earning $65,000 were living in a $535,000 house and trying to finance it with rental properties and debt! I'm sorry, but these people were living a pretty nice lifestyle (half million dollar home!) on borrowed money. Ordinary people who really work for their money rather than borrowing it have to pay taxes on it. Why should people who borrow and don't pay back not pay taxes? They got to live in the half million dollar home on someone else's buck. And so they should pay no taxes while the person who actually worked for the money should pay taxes? No way! This is absurd.
May 30, 2008 8:27 AM | Reply | Permalink
And, it's a half a million dollar house outside of Stockton that doesn't look anything other than a standard track home. These people obviously got caught up in the real estate game and weren't smart enough to know that their primary residence would never hold its value. I have a feeling many Californians are going to learn an important lesson in all this.
May 30, 2008 8:45 AM | Reply | Permalink
A minor correction needs to be made to your post Phil: the 2008 cap for Social Security is 97,500 not 90,000. Not that it really matters in the larger scheme of things I suppose.
May 30, 2008 8:39 AM | Reply | Permalink
The 2008 cap on Social Security taxes is $102,000 - meaning a couple both earning at the cap are paying $25K in Social Security tax and another $6K in Medicare taxes for a total of $31K annually exclusive of income taxes.
May 31, 2008 5:54 PM | Reply | Permalink
you make your bets, and you take your chances
these guys LOST
the United States Government does NOT exist to ensure that fools don't lose money
they need to suck it up and pay their bills
ain't my fault these idiots chose a poor investment scheme
May 30, 2008 8:46 AM | Reply | Permalink
I should clarify my point. It's that cancellation should be treated as investment loss, since that what it is--the house lost value not because of use but because of decline in value. The "punishment" for investment loss is the loss, not a tax bill for tens of thousands of dollars. This also involves unsophisticated, middle-class borrowers trying to profit from what has turned out to be a bubble. My argument is only that the treatment is unfair and inconsistent. (Compare their treatment by the government to that of major investment banks.)
Thanks also for the corrections--I appreciate it. My apologies.
May 30, 2008 8:56 AM | Reply | Permalink
The "punishment" for investment loss is the loss . . . .
But isn't the point that there was no "investment loss"?
They borrowed the money, and either because the lender waived the deficiency when accepting a deed in lieu of foreclosure or the mortgage was non-recourse, they don't have to pay the money back -- no loss.
Note: I don't necessarily disagree with your overall point. This was a problem during the early '80s Texas oil slump. But then, there were few record filing requirements, and my recollection is that the IRS didn't make an issue of chasing these folks.
May 30, 2008 10:09 AM | Reply | Permalink
Phil, debt cancellation is not a loss for the borrower--it's a loss for the lender. Say I lend you a $100,000. You don't pay me back. Who has the loss, you or me? The answer is obvious--I lose my $100,000--and you gain it. Debt cancellation is a gain for the borrower and a loss for the lender. The tax law makes perfect sense: the lender who loses the money can write the loss off (deduct it from income). The borrower who pockets the money pays income taxes on it because it's a gain for the borrower.
Now say you borrowed the money to invest (in a house or stock or any other appreciable asset) and used the purchased asset as collateral. If you fail to pay me back, I can take the asset (house, etc.) from you. In this case, my loss (and your corresponding gain) from the debt cancellation is limited to the difference between the amount you owe me and the value of the asset I received from you. You also have a loss--the capital loss on your asset (difference between its purchase price and its value when transferred to me)--which you can use to offset (subject to certain limits) any capital gains you have.
Note that in this transaction you didn't lose a penny in real dollars (since you put none of your own cash into the deal), but I lost $20,000. If you had done the same transaction using your own money (without taking any loan) you would have lost $20,000 of your own money. By taking the loan, you ended up $20,000 ahead (yes a real gain!) of where you would have been had you not taken the loan. That's why you're paying taxes--you gained $20,000.
I, the lender, meanwhile, lost $20,000--but I don't deserve any special breaks either. I should have been smarter and not lent money to a deadbeat like you.
May 30, 2008 1:16 PM | Reply | Permalink
It might be "unfair and inconsistent" but--just because the government did something stupid for the banks--that doesn't mean I think they should do something stupid for homeowners/speculators just to be "consistent." As a Democrat I'm realistic and fatalistic enough to know that the fat cats will always get bailed out. ($h!t flows downhill and money flows up.) They have made the compromises that it takes to be a leach on society and to exist at a more secure and remunerative economic level than I do. However, if the government bails out lesser leeches who operate at my economic level, then it gives them a direct advantage versus me--for example, undeserved home "equity" that they can leverage against me. As as liberal as can be when it comes to preventing the *next* housing crisis. But, as for this one, we need to stop bailing out leeches as soon as possible and start a new trend with which we can be fair and consistent rather than consistently unfair.
June 3, 2008 11:30 PM | Reply | Permalink
To a large extent, taxing "debt cancellation" is a problem for a property holder is a consequence of counting capital gains/losses as a separate class from earned income. (I had an analogous experience: as a software developer, I paid hundreds of thousands of dollars in taxes converting stock options, but when the dotCom dotBombed, the losses can be used only to offset the minor capital gains of my remaining taxable investment holdings. And yes, I was in the process of diversifying my investments, the destruction happened *very* quickly and I didn't escape it...)
I believe we should be having a conversation about whether the capital versus earned income distinction really makes sense. Capital gains are given substantially favorable tax treatment, and capital losses can only offset capital gains (beyond, i think a $3000 annual limit).
I do not believe that capital gains and income should receive separate and distinctly unequal treatment under the law. This is especially pernicious because transfer of money between the two classes usually favors those who have the resources to structure their financial dealings according to this byzantine ruleset.
This relates to the topic at hand: people who are taking a serious bath in their real estate property cannot count those losses against their ordinary income. This is a typical condition: A worker takes on a rental property for capital preservation and some income, though the work of maintaining rental property is significant. This is part of trying to have something to pass on to children, etc.
Tax policy is currently structured to increase risk for people trying to break into the "ownership" class, and to decrease risk for those who have completed the transition successfully.
May 30, 2008 9:43 AM | Reply | Permalink
Lenski, your situation is in many ways analogous. In your case, you exercised options and paid income taxes on the gain (the difference between the stock value and your discounted exercise price). When you sold your stocks later at a loss, you could only take only a limited capital gains deduction. In the case of the mortgage holder, the gain from debt cancellation is taxable as income (as was your gain at the option exercise), while the loss in the value of the house (like your loss on the sale of your stock) is a capital loss.
I'm for taxing income and capital gains at the same rates (maybe with an inflation adjustment for cap gains, however). I'm less certain about increasing the amount of capital losses you can write off--or allowing capital losses to be written off against income. That would create a very large tax shelter for big investors. I'd rather lower tax rates over all and limit the amount of deductions of all sorts.
May 30, 2008 2:54 PM | Reply | Permalink
Yes, I am in essential agreement with all those points, including limits on the extent to which capital losses can be deducted.
May 30, 2008 5:12 PM | Reply | Permalink
One of the reasons you paid ordinary income on the gain is because the options were provided to you as a form of employment income. You didn't "buy" the shares, rather, you received them in exchange for work. They were not, conventionally, an investment that you made with your own after tax dollars. What this highlights is that there is a substantial difference in the tax treatment of investment versus wages. It appears to be acute to you because in your case, the timing is off. Most people pay taxes on their wages immediately and only get to invest in their after tax dollars. You were given deferred tax status on stock options for pragmatic and fair reasons (it's hard to value options when given), and that made the nexus between the wage tax and the investment loss seem a lot closer than it was intended to be under the usual policy for taxing wages.
You could have liquidated the entire position upon the exercise and not incurred the subsequent investment loss and been in the same position as someone who had used after tax dollars to buy the investment to begin with. Instead, you decided to continue the investment because you made a decision, presumably, that it was the wise thing to do -- and you lost at least some money.
It can be hard to get tax policy right, but tax and security policies with respect to stock options are already screwed up enough, and incentivizing greater income through options in order to get even more tax advantages (taxes are already deferred) would probably not be a wise move.
June 2, 2008 11:14 AM | Reply | Permalink
One problem with the "investment loss" scenario is that the typical buyers didn't lose their investment, because (other than a minimal downpayment, whose loss is indeed deductible) they didn't have any money invested. So why should they get to take a loss on money that was never really theirs in the first place?
On the one hand, the hefty tax bill for the forgiven debt is nasty, but on the other hand, by maintaining a vacation house as personal property (instead of setting up a company to manage it) you're declaring to the IRS that you're using it at least partially for consumption (and that's even before the home equity line of credit).
The overarching problem is that the unregulated financing structure associated with the housing bubble allowed people to play roulette with far more money than they were in a position to lose; it's as if the feds had pre-empted Nevada gaming rules and said that everyone entering a casino was automatically admitted to the high-stakes games without any asset checks.
May 30, 2008 9:51 AM | Reply | Permalink
I think your clarified point is still mistaken. As someone else pointed out, the debt and the house are two different items from a tax perspective. Cancellation of the debt very clearly should be treated as income, not as a capital loss -- and the facts in this story show why.
In the NYT story, the couple purchased a house for $160,000 and expects to sell it for $160,000. However, they borrowed $280,000 against the house over the years. That money was used for consumption. The only reason it wasn't treated as taxable income when it was received was that the couple was expected to pay it back. Now that they won't, they should pay tax on the money they borrowed but spent and can't pay back.
Had the house actually declined in value below the purchase price (and it didn't), the NYT couple might have recognized a loss for tax purposes. Similarly, had it appreciated, they might have had a taxable gain. But that's a separate issue from the cancellation of the debt. As it turns out, the house didn't decline below the couple's basis. They just borrowed more against the house at some point, and then spent the money.
May 30, 2008 9:52 AM | Reply | Permalink
This isn't a criticism, but don't you have to distinguish between an income tax (which we have) and a consumption tax (which we don't have)? For example, we don't pay taxes on money received from a donor or a decedent no matter what we do with it.
May 30, 2008 10:17 AM | Reply | Permalink
The treatment might be different, but I don't think it matters here. Most consumption taxes probably would've taxed the people in the NYT story on their loan proceeds when they spent the money. Under our income tax, they got taxed later, when the debt was canceled.
Your earlier reply to Phil raises a good point, btw -- if the debt were non-recourse, then there wouldn't be any loss. And, under our tax code, I don't think there'd be any cancellation of indebtedness income, either. Which makes sense.
May 30, 2008 8:06 PM | Reply | Permalink
I'm with Purple State & Ebbet.
Imagine borrowing a ton to buy stock of equal value. If it goes up, you sell, repay the debt, and pay tax on the capital gain (which should really be taxed as ordinary income, but that's another story).
If it goes down, you hand the stock to your creditor and say bye-bye, no skin off my nose? I don't think so. Note the lender gets to write off the busted loan as a loss; a loss on one side has to be a gain on the other. The capital loss is the lender's, not the speculating home-buyer's.
If the borrower had flipped the house for a profit and repaid the debt, they would (and should) owe tax. The loss they incur with no debt forgiveness is consumption they must forego. Hence debt forgiveness is (and should be) consumption and taxable.
If they bought the second home with their own money and sold it for a loss, that would be a capital loss that could be used to offset capital gains (or ordinary income, if a gain was taxed like ordinary income).
The moral of the story is that you should not be borrowing an amount that is large compared to your net worth for investment purposes.
May 30, 2008 10:10 AM | Reply | Permalink
. . . a loss on one side has to be a gain on the other.
A minor but important point: the tax code is not constrained by accounting rules or any other forms of logic, simple or complex. It is what it says it is, and that's all it ever is.
May 30, 2008 10:26 AM | Reply | Permalink
They used the banks money to gamble in the real estate casino-not a crap shoot to gain sympathy or legislation. I frankly doubt the IRS has the staff to pursue all these sort of cases-In one of his cases, he said, a lender agreed that foreclosure “fully satisfies all obligations under the loan.” With that statement, he hoped, there would be no outstanding unpaid debt reported by the bank that the Internal Revenue Service could treat as income. - from the NYT piece.
May 30, 2008 10:59 AM | Reply | Permalink
Never commented before but this article is just
too outrageous.
As other commenters have pointed out, any down
payment the borrower lost on the house is already
deductible. The loss incurred by the *lender*
is pure consumption for the borrower.
Alternately, if the borrower
a) paid back the loan, and
b) sold the house
then, sure, let him take a deduction on the loss.
The idea that you get to
a) forfeit on a loan, and
b) treat the forfeited amount as *your* capital
loss
is simply insane.
May 30, 2008 11:23 AM | Reply | Permalink
OK, I may have been a bit too hasty with my
previous comment.
Let me see if I understand this properly. Perhaps
Mr Tedesco can correct me if I'm not.
I see 2 distinct trasanctions
The loan
---------
a) I borrow $1 mil from bank
b) I pay back $900k.
c) Bank writes off $100k.
Net income gain for me: $100k
The investment
---------------
a) I buy X for $1 mil.
b) I sell X for $900k.
Net investment loss: $100k
So am I to understand that if X was stock,
my income gain would be offset by the investment
loss, thus having no impact on my taxable income.
However, if X was a house and it was foreclosed
by the bank, the income gain is counted but the
investment loss is not, this resulting in an
increase of $100k in my taxable income.
Is this correct? Is this the distinction Mr. Tedesco is complaining about?
May 30, 2008 11:55 AM | Reply | Permalink
The house and stock investments are treated the same if both are investment properties. The gain from debt cancellation is taxed as income (higher tax rates) while the loss on the house or stock is taxed as a capital loss (lower tax rates, limited deduction, and deductible only against capital gains, not income). In general the tax paid on debt cancellation income will be greater than any tax saved as a result of the capital loss.
What Tedesco seems to be saying is that the tax on debt cancellation should be forgiven if the borrower ends up losing the borrowed money on an investment property that he purchased with the loan. But this would give deadbeat borrowers a huge tax advantage over responsible people who make the same investment with their own money. If I invest with my own money, I pay income taxes when I earn the money and if my investment tanks, I lose my money and the taxes I paid on it. In Tedesco's proposal, the deadbeat borrower transfers the loss to the lender and pays no taxes himself. The deadbeat is therefore at a huge advantage when compared with the responsible saver. This seems like a very poor outcome indeed.
May 30, 2008 3:37 PM | Reply | Permalink
While I am in favor of protecting primary residences, and those who are losing theirs to foreclosure, I don't see much value in protecting summer homes or "investment properties" in any way whatsoever.
Once you become a speculator, you ought to take on the liabilities as well as the benefits of the practice.
Any and all remedies to the foreclosure/mortgage/credit questions, whether they involve taxes or actual property, need to be based on that distinction. Primary residences get absolute priority, investment properties get seen to only after every primary residence question has been resolved.
May 30, 2008 1:14 PM | Reply | Permalink
Phil the capital gains tax, gain or loss, is meant to encourage risk taking and investment in a business that may create jobs, products or services playing with borrowed money in the real estate casino is not a comparable investment - in this case it created nothing but money for crooks in the mortgage business and an unsustainable bubble in home prices.
May 30, 2008 3:00 PM | Reply | Permalink
Firstly, I'm someone quite like lenski above...someone who incurred a huge tax burden when I exercised on my stock options (the difference between market price and strike price for options—well, the kind of options that regular employees receive—is considered by the IRS as work income immediately, not when the stock is sold) during the Internet bubble while simultaneously losing all that capital when the stock fell through basement. So I well understand the double-whammy of losing a bunch of money in a capital investment while also getting a huge tax bill. I was a front-line employee with mid six-figures wage income and a tax bill to match it...even though I never saw a large portion of that income ever in my bank account.
Even so, Tedesco is really off-base on this one. His rationale really doesn't make that much sense, as many others have already explained. A forgiven debt is income. Trying to talk about the forgiven debt in terms of the property's capital loss is nonsensical. They have nothing to do with one another.
If the US tax code were to be altered to do as Tedesco advises, there would be quite a few undesirable outcomes. For example, it would greatly privilege those who buy homes with borrowed money over those who buy homes with their own money. The economic effects of this would be huge, especially since we're not talking about primary residences here and thus anyone who invests in property would have this incentive. This is a bad, poorly considered idea.
Someone mentioned that you couldn't take a capital loss on your primary residence. I don't understand that. It would be economically distorting if it weren't for the fact that people don't primarily buy their domiciles for investment purposes. (Or, at least, they didn't use it.) So the added risk isn't a deterrent and the economic effects are presumably not large. Still, I can't think of a good reason for this other than increasing revenue to the treasury. Are these folks who have bought second homes able to take capital losses on them, unlike the case with primary residences? I'd be slightly more sympathetic to Tedesco's proposal if the capital loss is ignored and thus also treated idiosyncratically.
Lenski suggests that there shouldn't be a distinction between realized capital gains income and work income. I've thought the same, off and on, but it's important to note that changing this would have pretty strong effects. As someone explained, the rationale is that capital investment is one of the most important engines driving economic growth and thus it makes sense to privilege it over work. It's not about social justice, though that quite arguably should be in consideration here. That's why I don't like it, myself. It's absurd that the wealthiest pay very low taxes on their primary source of income (realized capital gains) while those of us who work pay higher taxes. (Incidentally, being single and financially uncomplicated, I filed 1040As for my mid-six-figures income. Who does that? I was happy to pay my tax bill, in general. I have no sympathy for people who whine about taxes.)
NobleCommentDecider, investment in real estate represents economic value, too, just as business investment and securities do.
May 30, 2008 3:40 PM | Reply | Permalink
Decisions regarding capital investment can be broadly valuable, using the power of individual research and risk acceptance to increase the care that is used when deciding among investment choices. So I agree that preferential treatment may be worthwhile to society. At present, however, the extreme concentration of financial power present in today's system has reduced the value of that argument. I argue that today, large capital holders are manipulating the investment marketplace with the power inherent in the concentration of their holdings, as well as their purchase of political influence, again with that selfsame capital.
In a rational world, where the participants have relatively similar access to information and relatively similar market power, capitalistic decisionmaking may "deserve" special treatment due to its intrinsic value to economic efficiency.
To argue the other side of the equation, though: The actual production of wealth is performed not by investors but by those who are working for earned income. I believe one could argue for a social engineering argument that society should encourage economically productive work by offering preferential tax treatment to those inclined to do so.
This is basically the crux of my argument that nobody receive preferential tax treatment (other than a gently progressive income taxation system with very straightforward rules of deduction) due to the factors balancing preferential treatment for capital movers versus income earners.
I do not suggest that this society *instantly* change the rules relating capital versus work income. I suggest rather a structure wherein a regular, periodic analytical process is used to adjust the rules of the road in a reasonably predictable way, with the goal being maintenance of economic balance.
A final rhetorical question: Does anyone, anywhere, think for a moment that someone who could be a capitalist would be discouraged from that role due to preferential tax treatment for work income? That just doesn't seem to be a viable argument. I for one would much much rather be an investor instead of busting my hump 12 hours a day trying to keep a job that someone else wants to devalue as much as possible.
May 30, 2008 5:41 PM | Reply | Permalink
A lot of tax theorists favor capital gains over wages and therefore argue for no or low capital gains taxation. And many also favor both capital gains and wages over consumption and therefore argue for a consumption tax to replace all income and capital gains taxation. But a healthy economy requires three things: investing, work, and consumption. Take away any one of these three, and the other two become worthless. If we tax any of the three activities, the tax will have an economic effect. Taxing capital gains reduces the amount of capital available for investment and also slows the flow of capital (since each capital sale because a taxable event). Taxing wages reduces consumption and investing, since workers have less to spend and save. Taxing consumption reduces consumption, since the taxes raise the price of goods. The effects are complex and it's by no means clear that taxing one of these three pillars of the economy is better or worse than taxing another.
Given this, I believe tax fairness should be our primary concern when developing tax policy. I think incoming wealth (from income and capital gains) is a better measure of real economic health than outgoing wealth (consumption) and therefore lean, from a fairness perspective, toward taxing income and capital gains rather than consumption. And since wealth is wealth, whether it comes from investing or work, I believe we should tax capital gains and income the same. The only exception I would make is an inflation adjustment for capital gains, since some of the increase in the value of capital is really just inflation and not a real gain. An inflation adjustment ensures that real gains are being taxed and not just inflation.
May 31, 2008 12:49 PM | Reply | Permalink
Someone mentioned that you couldn't take a capital loss on your primary residence. I don't understand that.
The tax code has some special rules for the sale of a primary residence. You can't write off a capital loss, but the first $250,000 in capital gains are also excluded from capital gains taxation. I think these rules were added to the code in recognition of the fact that most people aren't (or at least in the past weren't) buying and selling primary residences for investment purposes.
May 31, 2008 12:18 PM | Reply | Permalink
I just want to point out that you could have sold them when you exercised the options, thus reducing the risk to zero that you would incur a subsequent capital loss. As someone who lost quite a bit of money in tech stocks, I think that tech employees were probably very poorly advised by brokers, but in a very real way, they are not worse off than any of the rest of us. They just saw the link between the tax and the investment loss a lot more clearly.
June 2, 2008 11:36 AM | Reply | Permalink
investment in real estate represents economic value
True, yet I would say 'can represent' value, in the current 'housing bubble', many 'investments' did not create any value but were purely speculative, and destroyed capital that could have been put to more productive use.
May 30, 2008 4:38 PM | Reply | Permalink
Yes, but the same thing can be said, in spades, about securities bubbles like the Internet bubble.
May 30, 2008 5:23 PM | Reply | Permalink
What you are describing in this post about taxing "debt cancellation" income, is a form of "phantom income." This is a phenomenon I encountered when shutting down my "S" Corporation. I got burned with over $300,000 in phantom income, and no money to pay the taxes that were passed through to me. Fortunately, we figured out how to reduce that to a level that I could settle.
Since the tax liability passes through to the owners (stockholders) phantom income is a serious problem for people who go out of business due to a failure of the business. Our system punishes anyone who fails by taxing them for it, if they failed to pay off business loans, or deferred income at the end of the year, or used some other income deferrment allowed in the tax code. It adds up over the years. This is why any real estate investment activity should not be done as an LLC or "S" Corporation if you don't want to be caught in this tax trap. Same with a small businesses. The "tax benefits" that CPAs tell you about are not really benefits when all is said and done. They get you to pay just as much tax one way or another. At least if your business is a seperate tax entity, you don't get snared with "phantom income" on your personal tax return.
Our society is encouraging what the couple did in this NYT story. Borrowing money fuels our economy. So our government encourages their activity, until they can borrow no more, then they let the hammer fall because they aren't contributing anymore. People just need to learn to stop borrowing.
Check out this new movie on borrowing. http://wwjbmovie.com/ It is funny and entertaining! It also makes a good point.
May 30, 2008 6:46 PM | Reply | Permalink
I forgot to mention in my previous post. Forming a "C" Corporation is the way to avoid the "phantom income" on your personal tax return for businesses or real estate investments.
Jim
http://www.thetruthaboutcredit.com
May 30, 2008 6:50 PM | Reply | Permalink
I forgot to mention in my previous post. Forming a "C" Corporation is the way to avoid the "phantom income" on your personal tax return for businesses or real estate investments.
Jim
http://www.thetruthaboutcredit.com
May 30, 2008 6:51 PM | Reply | Permalink
Where did you get this idea? You should first understand why the original loan proceeds are not income: it is because the borrower has promised to repay them. Consequently, when subsequent events allow portions of the debt to be forgiven, the borrower is no longer obligated to repay proceeds that he or she had previously received. So it's income. Whether loan proceeds are used for consumption, investment, or curing cancer is irrelevant; all that is relevant is that one borrowed money and didn't include the loan proceeds in income, and thereafter was forgiven for some or all of the debt. That's the fundamental tax principle. And part of the problem you raise is addressed by sec. 108 of the Internal Revenue Code, which provides that debt forgiven in a bankruptcy proceeding is not income.
In terms of your argument that the forgiven debt should be a "capital loss," "Purple State" is correct that the loan and the home are considered separately for tax purposes. The parties from the NY Times article may have both capital losses and cancellation of debt income. If one borrows $500K to purchase an investment home for $500K, and then sells the home for $350K with the bank forgiving $150K of the debt, the taxpayer has cancellation of indebtedness income of $150K and a capital loss of $150K. What I think you intend to propose with your "capital loss" argument is that the capital loss and the debt cancellation income should be netted out such that there is no income tax consequences to the final transaction.
The tax consequences of debt cancellation are the same for leveraged real estate investors and leveraged hedge funds. I'm not sure I understand your "unfairness" argument. [I'll leave the debate about hedge fund "carried interest" tax rates for another day.]
Lastly, you and "Jeannie See" are both mistaken: the cap on OASDI for 2008 is at $102,000 of wage income.
May 30, 2008 9:34 PM | Reply | Permalink
re: When a mortgage is forgiven, the principal not paid back is considered, like any other unpaid debt, income and taxed accordingly.
There were already numerous exclusions and exceptions to that before the recent change in the law. Anyone with a good tax preparer could beat the IRS on this one, provided they acted quickly.
Re: They borrowed the money, and either because the lender waived the deficiency when accepting a deed in lieu of foreclosure or the mortgage was non-recourse, they don't have to pay the money back -- no loss.
Note: in a non-recourse mortgage there would never (in principle) be a tax liability after foreclosure. Because the mortgage holder cannot legally pursue the mortgager for any unpaid debt, there is no debt amnesty.
Re: Debt cancellation is a gain for the borrower and a loss for the lender.
If the borrowr keeps the money, or what was purchased with it, yes. The point here is that the borrower has not kept the money-- the lender has taken it back in the form of the foreclosed property.
May 30, 2008 10:45 PM | Reply | Permalink
The point here is that the borrower has not kept the money-- the lender has taken it back in the form of the foreclosed property.
But the foreclosed property isn't worth the amount of money owed. The borrower still owes the lender the difference between the total amount owed and the value of the property. If that difference is cancelled, then the lender loses that money and the borrower has a gain. Effectively, the lender is paying the borrower the remaining amount owed.
A lot of folks seem to be laboring under the misconception that in a mortgage, the lender and borrower are buying the house together as a joint investment. That's not the case. The lender is lending money and simply securing the loan by the value of the property the borrower is buying. The lender isn't at all responsible for the investment performance of the house the borrower chooses to buy. If the lender were responsible, the lender would demand a much greater say in the particular home the borrower buys, how the borrower maintains it, and even when the borrower sells it. Lenders aren't co-buyers or co-investors. They just rent you their money for a period of time--and you have to give it back. If you don't give it all back, then the amount you keep is income. The fact that you've already spent that income on a depreciating asset is irrelevant. You got the money. You spent it. It's yours. Pay the taxes.
May 31, 2008 10:32 AM | Reply | Permalink
I agree it's totally unfair that capital gains are tax privileged over wage income. It's also economically counterproductive. It's also ridiculously unfair to extend the capital gains privilege to hedge fund managers' wages.
However, it's perfectly appropriate to tax the unpaid loan as income. It is income, and if it were any other way, it would be a huge loophole.
May 31, 2008 12:35 PM | Reply | Permalink
Or, in the alternative, it's totally unfair that capital gains are taxed, at all.
Capital gains -- probably better described as "holding gains" -- are derived from a combination of the government's depreciation of its currency ("inflation") and the willingness of the investor to forgo current income ("corporate retained earnings").
For the vast majority of Americans who consume almost everything they earn (and whose earnings rise with inflation) the income tax on earnings is, really, a consumption tax. Why not bite the bullet, drop the income tax and enact a consumption tax applicable to everyone?
May 31, 2008 2:26 PM | Reply | Permalink
This is simply wrong. Let's say that this couple had invested their own money in the house. This money would have already been taxed as income, whether wage or investment income. If the property values tanked and they had to sell the investment, they would have lost all the money that they had earned, and would not be able to claim any deduction. But the facts are, the couple haven't actually lost anything with the collapse in the value of the house -- because they never put anything into the investment.
The only issue here is whether they should have to pay taxes on the debt forgiveness as investment earnings (because the money was used for investment purposes) or ordinary income.
Anyone arguing for broad based investment related tax relief needs to understand how such relief would work for the benefit of those willing to utilize tax shelters for their income. Also, the availability of tax forgiveness would be a real spur to reckless real estate investment, like we need more of that.
It's unfortunate that this couple find themselves in such a bind, but that's what bankruptcy is for. It's enough to provide relief to people with respect to their primary residences.
June 2, 2008 11:28 AM | Reply | Permalink
I should say, whether they could claim a deduction for the loss depends on a lot of other tax recognition principles. Many losses are not deductible at all, especially long term losses, unless they are used to offset capital gains. Part of prudent tax management is to make strategic sales of assets to manage tax consequences. If all you have are gains, well, no one is going to worry too much about your tax burden.
June 2, 2008 11:40 AM | Reply | Permalink