The Most Outrageous Tax of the Year

It just may become the latest outrage during a year of outrages. At the precise moment when the federal government finally delivers a modicum of justice and some economic relief to millions of homeowners victimized by the nation’s largest banks, the government threatens to beat those victims over the head with a punitive old favorite revenue raiser — a tax on forgiven debt.

Here’s the backstory: After years of standing on the sidelines and ignoring evidence that major banks were using their mortgage servicing arms to steal money from innocent consumers and illegally evict homeowners, the federal government finally joined with 49 states to prosecute the banks. It was a frustrating,  agonizingly slow and painful process that led to an even more frustrating, agonizingly slow and painful negotiation.

The result was the National Mortgage Settlement, in which the five largest loan servicers must pay $21.5 billion in reparations and restitution to consumers victimized by their inappropriate conduct. Specifically, many homeowners whose mortgages were serviced by the Big Five — Citi, JPMorgan Chase, Wells Fargo, Bank of America and Ally Financial — may qualify for significant reductions in their mortgage principal and interest rates. And 1.5 million people who lost their homes due to questionable foreclosure practices can apply for a one-time payment of $2,000 (an insultingly low figure considering how much pain is involved in losing one’s house).

Altogether, that’s not an inconsequential number even in an imperfect world. More importantly, it’s desperately needed right now by millions of underwater homeowners, who just might be able to hang onto their homes if they can receive the lower payments that come from interest and principal reductions. That helps individual homeowners, and it also helps everyone else, since our economy needs more foreclosures and more empty houses like it needs another global stock market crash.

But a grid-locked, polarized Congress is about to screw it up (again). You see, unless Congress acts with uncharacteristic speed and bipartisanship, anyone who might receive a principal reduction from the mortgage settlement could face a hefty tax bill.

That’s not supposed to be the way this all goes down. In 2007, Congress enacted the Mortgage Forgiveness Debt Relief Act, which prevents homeowners from paying taxes when their mortgage debt is forgiven due to a decline in the owner’s financial life or a drop in the home’s value. (We first covered the debt cancellation tax, known as the 1099-C, early last year, and gave tips on what to do if the IRS taxes you on cancelled debt.)

The law applies to homeowners who participate in the National Mortgage Settlement who receive up to $2 million in reduced principal and interest charges. It is scheduled to expire at the end of 2012 along with all the other tax cuts we have heard about for years.

Whoops.

So, instead of getting the relief they need to save their houses, victimized homeowners will be forced to pay a significant portion of that savings to Uncle Sam. Since the average homeowner will receive about $19,000 in settlement relief, and the average middle class family pays about 25 percent in taxes, approximately one quarter of the forgiven debt — some $4,750 — will have to be paid to the IRS and by those who can least afford to pay it. For some families, that could be enough to tip the scales, pushing them back to the brink of foreclosure and eviction.

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