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Republican Dan Lungren Working to Gain Support to Avoid Principal Reduction Tax Time Bomb

Here’s some good news in an otherwise dispiriting Congressional session. A Republican House member is trying to accumulate support for a bill that would extend the Mortgage Forgiveness Debt Relief Act by three years. As I’ve been reporting, a failure to extend this law would mean that all debt forgiveness, in the form of principal reductions or short sales, would be viewed for tax purposes as earned income for the borrower, leading to a giant tax bill on the phantom income.

Thus far, the Senate Finance Committee passed a bipartisan tax extenders package that included a one-year extension of cancelled mortgage debt relief. Jim McDermott introduced a bill on the House side that had all Democratic co-sponsors. A similar bill from Republicans, introduced by Rep. Dan Lungren, has just four Republican co-sponsors. However, Lungren’s legislative aides are currently seeking additional support for their bill, H.R. 4250. An aide recently sent out an appeal to Congressional offices to sign on to their legislation. Here’s the message attached:


At the end of this year, any of our constituents who have been subject to a short sale, or loan modification or foreclosure could find themselves subject to a tax bill on the amount of the mortgage debt a lender forgave or cancelled. This is tantamount to throwing an anchor to many of those who already find themselves under water. With unemployment still above 8 percent and a housing market which has yet to fully correct itself, Congressional action is necessary to extend this existing provision in our tax law.

H.R. 4250 would provide a life preserver for those facing this pending tax disaster. It would extend for 3 years the current exclusion from income of discharged indebtedness for qualified principle (sic) residences.

If this provision of the tax code (I.R.C. §108(a)(1) is not extended many struggling homeowners will face the shock of a tax bill to add to their misfortune.

The email also included a a report from the Congressional Research Service highlighting the issue. The CRS report does a good job explaining why the Mortgage Forgiveness Debt Relief Act is crucial. In general terms, mortgage debt forgiveness would only be exempted from gross income if the debt was discharged in bankruptcy, or if the borrower is deemed “insolvent,” with liabilities that exceed assets, prior to the discharge of the debt. But this really only defers the tax on the income. CRS explains why we’re in such an environment where more help is needed for these homeowners:

Over the past quarter century, Congress has enacted tax relief for canceled debt in several instances, including assisting Hurricane Katrina victims in 2005 and commercial property owners and farmers during economic downturns in 1986 and 1993. The 2005 legislation was temporary while the others were permanent.

It could be argued that the market conditions that led to the 1986 and 1993 congressional enactments also exist today. Specifically, property values may be declining such that the property no longer supports the debt with which it is encumbered. Currently, the policy issue is posed by residential housing; in 1986, the problem was the business property of farmers; and in 1993, the issue was business real property. In providing the 1993 exclusion, Congress acknowledged it was essentially allowing the taxpayer to defer the income subject to tax because an adjustment to basis was required.

What CRS does not explain is that the borrowers who will be most affected by this change are those receiving a principal reduction or a short sale as part of the 49-state foreclosure fraud settlement. Those borrowers are getting debt forgiveness to redeem a penalty on the banks for abuse. There is no reason on earth that government should participate in that penalty by stripping large percentages of it from the borrower, especially because this would defeat the purpose of improving the borrowers’ balance sheets.

The fact that Lungren, the Chairman of the House Administration Committee and as such someone who has the ear of leadership, is now moving again to scoop up co-sponsors for the bill suggests that the legislation could be in play. The fear was that the House would be the brick wall for the extension, after the Senate included it in their tax extender package. But if Lungren, who represents an area hard-hit by foreclosures and who faces a difficult re-election campaign, can amass more Republicans to his side, maybe he can generate enough support to get the bill included in a tax extender package on the House side. His actions raise those hopes.

Maybe this will be part of the discussion at that House Ways and Means closed session on Thursday.

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David Dayen

David Dayen