“Tax Nightmare” of Eminent Domain Mortgage Seizures

Courtesy of Mish.

Gayle McLaughlin, mayor of Richmond, California is hell-bent on her plan to seize mortgages via eminent domain, then provide “mortgage forgiveness” for the homeowners.

I smacked the idea from a legal standpoint in Illegal Public Seizure of Mortgages Via Eminent Domain in the Spotlight.

Tax Nightmare

Legalities aside, there are also huge tax consequences to consider.

A local attorney and real estate broker posting under the name “davecherr” commented on the problem of debt forgiveness.

There is a massive and thus-far unremarked upon problem with this ED scheme: it would result in a MASSIVE INCOME TAX BILL FOR THE HOMEOWNER. Under the tax code, discharge of indebtedness is counted as income. There is a safe harbor for people who lose their primary residence to foreclosure, but it would not apply to these Richmond residents, since they would keep their house with magically reduced debt.

That debt reduction would NOT be tax-free. If a homeowner’s mortgage goes from $400K to $190K under the proposed scheme, they would owe taxes on $210K of discharged debt (it would likely be much more, because all missed payments, late fees, and missed property tax and insurance payment, and interest on all of that, would be folded into principal — such costs can easily drive principal from $400K to $500K over the course of 1-2 years of non-payment).

The federal taxes on that would be around $50K, and the state taxes $15K, for a total tax bill of $65K, or around $7K per year on a 15 year payment plan. As a local, I can tell you that most residents of Richmond do not have an extra $7K/year of income to pay such a bill. 

Who will tell the people of Richmond, and their craven politicians, that their scheme will lead to tax nightmares exploding all across their fair city?

Mortgage Forgiveness Act of 2007 Expires

Sure enough, “davecherr” is correct. Details can be found in the IRS publication Home Foreclosure and Debt Cancellation.

Update Dec. 11, 2008 — The Mortgage Forgiveness Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualify for this relief.

This provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion doesn’t apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.

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