On August 31, President Bush offered a small package of
initiatives to address developments in the housing and mortgage
markets. One element of the package was a proposal to provide
special and temporary tax relief to those who lose their homes
during the current period. The Administration's tax proposal, while
well intentioned, is nevertheless misguided and all the more
unfortunate because the Administration missed an opportunity to
provide tax relief through sound tax reform.
A Tax Balm for the Subprime Pain
This paper does not detail the many factors that have contributed
to the current troubles in the mortgage and housing industries. In
summary, a great many home buyers, mortgage companies, and
investors made a lot of bad decisions, often by misunderstanding
and misusing some new, valuable financial innovations.
As a consequence of these bad decisions, credit and housing
markets are going through a period of painful adjustment. Many
families are going to lose their homes. Whatever the Administration
proposes and Congress enacts in the coming months, policymakers
must recognize that their actions will not alter this fact.
Adding insult to injury, the tax code today heaps an extra and
excessive tax burden on families who lose their homes. The tax code
treats the value of cancelled mortgage debt as taxable income. For
example, when a family loses its home, the house becomes the
property of the lender, who then tries to sell it to recover as
much of the original loan's value as possible. If the house sells
for $300,000 and the outstanding mortgage was for $400,000, then
the difference of $100,000 represents a loss for the lender. That
$100,000 is the value of the cancelled mortgage debt for the former
under current law, it is added to the family's taxable income.
The Administration proposes to exclude, on a temporary basis,
cancelled mortgage debt from taxable income. To be clear, this
policy is not intended to help the housing or financial markets
through the adjustment period. Its sole intent and consequence
would be to provide some tax relief to former homeowners.
The Administration's desire to help these families is well
intentioned, but the proposed solution is off base. If done on a
permanent basis, eliminating the tax on cancelled mortgage debt
would provide an unwarranted and distortionary tax loophole under
certain economic outcomes. The value of the cancelled mortgage is a
beneficial gain to the former borrower which, under income tax
principles, should be subject to tax. Eliminating the tax
altogether would be, in effect, a tax-based mini-bailout for former
borrowers who, it must be remembered, are in their current
straights largely as a result of their own poor decisions.
The Administration's proposal is inappropriate even on a
temporary basis. There is no reason to exempt an individual from
this tax simply because he or she is joined by thousands of others
and to restore the tax for a normal year when only a few hundred
people must pay it.
A better way to provide tax relief to homeowners would be through
sound tax reform. The tax code treats cancelled debt as taxable
income. Cancelled debt should be treated as a capital gain and, in
almost all instances, as a long-term capital gain. As such, it
would be subject to, at most, a 15 percent tax rate. If the tax
relief resulting from this reform were not enough, the
Administration could have proposed allowing homeowners to delay
recognition of the gain for a year or two. The delay would give
families time to restore their finances before facing a tax hit.
The additional relief would constitute "special treatment" for
these families, but such are the proper decisions for policymakers
as long as the relief is permanent.
Treating cancelled mortgage debt as a capital gain makes sense
in a couple ways. One way is to think of debt as a negative asset.
If an asset like a bond rises in price, the increase is capital
gain; if it falls in price, the reduction is capital loss. If debt
is considered a negative asset to the debtor, then a decline in the
value of the debt should carry the same tax consequence as a rise
in the value of any asset-namely, as a capital gain.
Also, the current treatment of cancelled mortgage debt violates
the principle of symmetry that underpins much of a proper income
tax. Under this principle, for example, wages are taxable to
workers, and the symmetrical treatment is that they are deductible
to businesses. Borrowers can normally deduct interest expense from
their income, while lenders must normally include interest income
in their taxable income. When mortgage debt is cancelled, the
lender suffers a capital loss; the debt, which is an asset held by
the lender, is wiped from its books. In that instance, the
principle of symmetry should deem that the original borrower has
received a capital gain.
Correcting the tax treatment of cancelled mortgage debt would
give these families a significant dose of tax relief. A taxpayer in
the 15 percent income tax bracket faces a 5 percent capital gains
tax rate. Thus, treating $10,000 in cancelled debt as capital gain
rather than income cuts this taxpayer's associated tax liability by
two-thirds, or by $1,000. For a taxpayer in the 28 percent income
tax bracket, capital gains treatment cuts the taxpayer's tax burden
by almost half, or by $1,300.
A sound and sensible means to reduce the bite of the federal
income tax on families who have recently lost their homes to
foreclosure is to correct the tax treatment of cancelled mortgage
debt. The current treatment as taxable income violates normal
income tax principles. The correct treatment would be as capital
gain and, in almost all instances, long-term capital gain. If
additional tax relief for these families is deemed appropriate,
Congress can allow them to delay, for a year or two, payment of the
tax on the capital gain.
JD Foster, Ph.D., is
Norman B. Ture Senior Fellow in the Economics of Fiscal Policy in
the Thomas A. Roe Institute for Economic Policy Studies at The