Avoiding Insult to Injury: Extending and Expanding Cancellation of Indebtedness Income Tax Exemptions for Homeowners

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1 Avoiding Insult to Injury: Extending and Expanding Cancellation of Indebtedness Income Tax Exemptions for Homeowners Dustin A. Zacks This article offers a critical analysis of anti-homeowner arguments that have arisen in the wake of the enactment of the Mortgage Forgiveness Debt Relief Act of 2007 (MFDRA), which excludes forgiven principal residence indebtedness from generating federal income tax liability. Some argue that forgiveness encourages housing speculation and overconsumption or benefits wealthy homeowners more than homeowners of moderate means, while others suggest that forgiveness is not fair to homeowners who paid such taxes prior to Congress s exemption being enacted. This article asserts that such criticisms, even if facially valid, are overstated and do not overcome the importance of eliminating existing homeowner incentives to file bankruptcies in order to avoid cancellation of indebtedness income tax. Furthermore, excluding cancellation of indebtedness income tax prevents disincentives to homeowners from seeking to modify their home loans. Aside from addressing scholarship regarding the temporary Congressional exclusion of principal residence indebtedness, this article also proposes an expansion of the permanent exclusions to cancellation of indebtedness taxation in the Internal Revenue Tax Code (the Code). In particular, the existing purchase-price exception to cancellation of indebtedness taxation should be expanded. Because the purchase-price exception only applies to original lenders negotiating with original purchasers, the exemption has effectively been eliminated for a large Dustin A. Zacks is a member of King, Nieves & Zacks PLLC in West Palm Beach, Florida; B.A., University of Michigan, 2004; J.D., University of Michigan, The views expressed herein are solely those of the author and should not be attributed to the author s firm or its clients.

2 318 ARKANSAS LAW REVIEW [Vol. 66:317 portion of homeowners whose loans have been sold on the secondary market. This article argues that the theoretical justifications for the purchase-price exception should apply whether or not a home loan has been sold, as homeowners exercise no control over whether their loans are transferred from lender to lender. The Code already allows for subjective considerations of infirmity and impropriety at origination to equitably justify the purchase-price exception, and this article asserts that such considerations should be even more closely examined in light of the wildly inflated property values and subprime and exotic loans presented to homeowners at the height of the bubble. Therefore, even without a permanent extension of the MFDRA s temporary exemption, expanding the purchaseprice exemption would provide homeowners with incentives to renegotiate their home loans or to negotiate walkaways rather than filing for bankruptcy. I. INTRODUCTION The housing crisis produced a number of obvious side effects and symptoms, including an escalating number of foreclosures, a precipitous decline in property values, and a sharp downturn in the real-estate market. As a result of financial hardship or a decline in property values, many homeowners under threat of foreclosure opted not to attempt to modify their loans but, rather, to attempt a short sale or a deed-in-lieu-of-foreclosure settlement to escape liability for a potential deficiency between the selling price of the distressed property and the amount owed on the original loan. 1 For federal income purposes, the cancellation of indebtedness (COD) is generally considered ordinary income. 2 Thus, many homeowners were placed at risk not only of losing their homes, but also of owing thousands of dollars in income taxes. As a result of the escalating risk of former homeowners owing taxes on properties they surrendered, 1. Fannie, Freddie Short Sales Hit Record High, INMAN NEWS (Jan. 7, 2013), (noting nearly 38,000 such settlements among Fannie Mae and Freddie Mac loans in the third quarter of 2012). 2. See I.R.C. 61(a)(12) (2006).

3 2013] TAX EXEMPTION FOR HOMEOWNERS 319 Congress passed the MFDRA, which forgave COD income stemming from forgiven liability on primary home loans. 3 A year later, Congress extended the relief until the end of Therefore, as Congress wrestled with the approaching fiscal cliff of 2013, the MFDRA faced extinction, and distressed homeowners faced the possibility that in 2013 they could surrender their homes only to confront income tax liability. In an eleventh-hour bill to avoid the fiscal cliff crisis, Congress extended the MFDRA once again to December 31, The academic reception to the MFDRA was chilly at best, with some commentators voicing outright hostility to the idea of forgiveness. 6 The primary arguments against COD income tax forgiveness are that it encourages homeowners to overconsume or buy larger houses than they otherwise would have, that it benefits wealthy taxpayers more than ordinary homeowners, and that it violates fundamental fairness to those who paid COD income tax prior to the congressional acts. 7 This article engages the existing arguments against forgiveness and argues that such views, even if facially valid, are vastly overstated. The article stresses that forgiveness is vitally important in steering homeowners away from bankruptcy. Finally, forgiveness respects fundamental fairness by recognizing that many homeowners were taken advantage of at the height of the bubble through overstated appraisals and through the extension of exotic and expensive loan terms when they otherwise could have afforded more reasonable terms. 3. Mortgage Forgiveness Debt Relief Act of 2007, Pub. L. No , 121 Stat (2007) (codified as amended in scattered sections of the I.R.C.); see Mortgage Workouts: Now Tax-Free for Many Homeowners, INTERNAL REVENUE SERVICE, Homeowners%3B-Claim-Relief-on-Newly-Revised-IRS-Form (last updated Aug. 3, 2012). 4. Emergency Economic Stabilization Act of 2008, Pub. L. No , 303, 122 Stat. 3765, 3807 (2008) (codified in part at I.R.C. 108); see Mortgage Workouts, supra note American Taxpayer Relief Act of 2012, Pub. L. No , 126 Stat (2013). 6. See infra Part III. 7. See infra Part III.

4 320 ARKANSAS LAW REVIEW [Vol. 66:317 The article argues that, even if Congress had not extended temporary tax relief to struggling homeowners, the Code s current purchase-price exception should be extended to encompass cases where property values have vastly declined but the original lender is not the current owner of the loan. The jurisprudence regarding the purchase-price exception to COD income already considers equitable concerns such as infirmity and fraud at origination. 8 This article posits that such equitable considerations should be even more closely examined in light of the vast amounts of questionable lending practices that occurred at the height of the housing bubble. Part II briefly explains the genesis of COD income tax and discusses the congressional acts that forgave such taxes in the case of primary-home loans. Part III counters the existing literature and the anti-forgiveness arguments propounded by scholars and commentators. Part IV discusses the fundamental reasons why forgiveness should be extended. Part V explains the purchase-price exception and describes how and why it should be permanently extended to relieve homeowners in a down housing market. Part VI concludes the article. II. THE STATE OF THE LAW AND THE MFDRA Uniquely among nations, the United States recognizes and taxes as income those debts forgiven by creditors. 9 Because income recognized from cancellation of indebtedness does not result in cash in the hand of the taxpayer, such income has sometimes pejoratively been called phantom income, producing a bill for money that they never saw. 10 The long and winding road of the development of COD income tax treatment has often been 8. See infra notes and accompanying text. 9. Richard C.E. Beck, The Tax Treatment of Cancelled Interest and Penalties on Consumer Debt, 53 N.Y. L. SCH. L. REV. 1025, 1026 (2009). 10. Rue Toland, Note, No Tax for Phantom Income : How Congress Failed To Encourage Responsible Housing Consumption with Its Recent Tax Legislation, 85 CHI.-KENT L. REV. 345, 353 (2010) (quoting 153 CONG. REC. H11, 291 (daily ed. Oct. 4, 2007) (statement of Rep. Philip English)); see also Joseph C. Mandarino, The Tax Effects of Debt Cancellation A Primer for Non-tax Lawyers, 24 PROB. & PROP. 20, 21 (2010).

5 2013] TAX EXEMPTION FOR HOMEOWNERS 321 discussed in academic texts. 11 Despite the extent to which COD taxes and exceptions thereto have been discussed, no uniformly accepted theory to justify such taxation exists. 12 In light of the lack of a unifying theory, judges and Congress have mitigated the harshness of recognizing COD income by creating exceptions and deferrals dating back to the Great Depression. 13 First, judges created an insolvency exception, later codified in 1954, providing that insolvent debtors can be eligible for a waiver of COD taxes. 14 However, the IRS and the courts have drastically reduced the insolvency exception over time. 15 Secondly, the purchase-price exception provides that when an original lender bargains with an original purchaser, a reduction in principal may be deemed an exception to COD income in cases of failing market conditions or reduced property values. 16 Third, amounts discharged in a bankruptcy proceeding are not deemed COD income. 17 Fourth, debts subject to a bona fide dispute as to amounts due do not generate COD income tax liability. 18 The development of these exceptions has always been controversial. 19 As this article examines, the congressional exemption for primary residence COD income has generated similar controversy and consternation. In the context of the housing crisis, COD income taxes and the existing exceptions regained scholarly attention as 11. See, e.g., James L. Musselman, Is Income from Discharge of Indebtedness Really Income at All? A Proposal for a More Reasoned Analysis, 34 U. MEM. L. REV. 607, (2004) (providing a historical examination of the taxability of income from the cancellation of debt). 12. Id. at Monica D. Armstrong, From the Great Depression to the Current Housing Crisis: What Code Section 108 Tells Us About Congress s Response to Economic Crisis, 26 AKRON TAX J. 69, (2011). 14. See I.R.C. 108(a)(1)(B) (2006); see also Armstrong, supra note 13, at 77, Casey R. Kroma, Cancelled Debt and the Unexpected Tax Burden, 79 REV. JUR. U.P.R. 375, (2010). 16. See I.R.C. 108(e)(5) (2006); see also Armstrong, supra note 13, at See I.R.C. 108(a)(1)(A) (2006); see also Curt Hochbein, Comment, Mortgage Forgiveness Debt Relief Act of 2007, 38 CAP. U. L. REV. 889, 919 (2010). 18. Mandarino, supra note 10, at 22 (noting that disputing the enforceability of a debt does not alone trigger the purchase price exception without a dispute as to the amount owed); Martin J. McMahon, Jr. & Daniel L. Simmons, A Field Guide to Cancellation of Debt Income, 63 TAX LAW. 415, 435, 439 (2010). 19. Beck, supra note 9, at 1026.

6 322 ARKANSAS LAW REVIEW [Vol. 66:317 distressed homeowners sought loan modifications and forgiveness of home loans. First, in cases where homeowners sought to keep their homes with modified loan terms, such modifications have traditionally been treated as COD income if such modifications are deemed significant. 20 Significant modifications include a change in the interest rate of at least twenty-five basis points or a five percent change in the annual yield. 21 Thus, in a market where millions of homeowners are either delinquent or in foreclosure, 22 loan modifications may sometimes raise the spectre of tax liability to homeowners. Secondly, in cases where homeowners were unwilling or unable to modify their loans, short sales and deeds in lieu of foreclosures have generated COD taxation discussions. 23 In such scenarios, homeowners bargain for a settlement whereby a lender accepts less than the full amount owed in return for a sale to a third party or for the relinquishment of the deed. 24 In return for generating such a sale or for returning the property to the lender in acceptable condition, lenders often waive their right to collect the deficiency, the difference between the amount owed on the original loan and the amount actually realized through a short sale or a foreclosure auction. 25 The forgiveness of the remaining debt owed is a classic example of COD income and would normally generate tax liability at ordinary income rates. 20. See Treas. Reg (a) (2012) ( [T]he gain or loss realized... from the exchange of property for other property differing materially either in kind or in extent, is treated as income or as loss sustained. ); Treas. Reg (b) (2012) ( A modification that is not a significant modification is not an exchange for purposes of (a). ); see also Mandarino, supra note 10, at See Mandarino, supra note 10, at Paul Kiel, Foreclosure Fail: Study Pins Blame on Big Banks, PROPUBLICA (Sept. 11, 2012, 11:35 AM), (noting that two million people remained in foreclosure in late 2012). 23. See infra Part IV.C. 24. See Francie Cohen Spahn, Deeds in Lieu of Foreclosure, PRAC. REAL ESTATE LAW., July 2010, at 47, 47-48; see also In re Anderson, No SSM, 1997 WL , at *6 (Bankr. E.D. Va. Aug. 29, 1997). 25. Some states limit a lender s ability to pursue a homeowner personally to collect a deficiency. See 1 GRANT S. NELSON & DALE A. WHITMAN, REAL ESTATE FINANCE LAW 8.3 (5th ed. 2007); see also Weinstein v. Rocha, 145 Cal. Rptr. 3d 93, (Ct. App. 2012) (discussing California s anti-deficiency statute).

7 2013] TAX EXEMPTION FOR HOMEOWNERS 323 Many lenders were keen to forgive potential deficiencies in exchange for a short sale or deed-in-lieu settlement. 26 Through such settlements, lenders avoid a drawn out and expensive foreclosure process and further risk deterioration of the property. For homeowners, such settlements are an optimal pathway to avoid liability and evade the necessity of a bankruptcy to avoid a lender pursuing a deficiency judgment. Unfortunately, homeowners utilizing waivers of deficiency faced a gloomy prospect: they could declare bankruptcy and discharge personal liability, or they could settle with their lender and face ordinary income taxes on the amount forgiven. 27 Given that COD income is taxed at ordinary income rates, many homeowners were faced with a Hobson s choice between a bankruptcy costing a few thousand dollars in attorney s fees and a settlement with a lender generating many more thousands of dollars of tax liabilities. The escalating number of homeowners who faced such an unpleasant choice eventually garnered congressional attention. In 2007, Congress passed the MFDRA. 28 The Act created a new exception to COD income tax: forgiveness of debt stemming from the purchase of a qualified principal residence. 29 Experts have predicted that the MFDRA has saved taxpayers more than $600 million dollars in the three-year span from 2007 to Congressional rationales for the forgiveness generally referenced the desire to avoid punishing people who were perceived as already being in an unfortunate situation. 31 In 2008, Congress extended the MFDRA to include debt 26. See Fannie, Freddie Short Sales Hit Record High, supra note See I.R.C. 61(a)(12), 108(e)(1) (2006); see also Armstrong, supra note 13, at 77; Hochbein, supra note 17, at See Mortgage Forgiveness Debt Relief Act of 2007, Pub. L. No , 121 Stat (2007) (codified in scattered sections of the I.R.C.); see also Mortgage Workouts, supra note I.R.C. 108(a)(1)(E) (2006 & Supp. V 2011). 30. Thomas A. Humphreys, Tales from the Credit Crunch: Selected Issues in the Taxation of Financial Instruments and Pooled Investment Vehicles, 7 J. TAX N FIN. PRODUCTS 23, 29 (2008). 31. Rachel Carlton, Recent Development, Mortgage Forgiveness Debt Relief Act of 2007, 45 HARV. J. ON LEGIS. 601, 601 (2008).

8 324 ARKANSAS LAW REVIEW [Vol. 66:317 forgiven through December 31, Congress recently passed another short-term extension of the MDFRA; it is now set to expire on December 31, Reaction to the congressional benevolence was swift and harsh. III. THE ANTI-FORGIVENESS ARGUMENTS AND THE WEAKNESSES THEREIN Commentators have frequently criticized politicians for singling out real estate and homeownership for beneficial tax treatment. 34 The congressional exclusion of COD income for homeowners generated further concerns in this respect. The chief arguments against forgiving homeowner COD taxes include that such forgiveness spurs overconsumption and speculation, generates fairness concerns, creates a regressive tax structure, and penalizes previous payers of COD taxes. This article critiques these arguments in turn. The article also examines other tangential arguments made in the face of homeowner COD tax forgiveness. A. Forgiveness Spurs Speculation Perhaps the most virulent critic of the MFDRA and of COD forgiveness, Bradford Anderson, continually asserts that forgiveness is not justified due to its benefits accruing to real estate speculators. 35 Anderson repeatedly refers to the effects of the MFDRA on speculators and people who roll the dice on real estate. 36 He asserts that COD forgiveness adds fuel on the fire of real estate speculation. 37 Several glaring errors exist with regard to this argument against COD forgiveness. 32. Emergency Economic Stabilization Act of 2008, Pub. L. No , 303, 122 Stat. 3765, 3807 (2008) (codified in part at I.R.C. 108); see Mortgage Workouts, supra note American Taxpayer Relief Act of 2012, Pub. L. No , 126 Stat (2013). 34. Humphreys, supra note 30, at 30 (criticizing the MFDRA for making housing even more favored in the tax code). 35. Bradford P. Anderson, Robbing Peter To Pay for Paul s Residential Real Estate Speculation: The Injustice of Not Taxing Forgiven Mortgage Debt, 36 SETON HALL LEGIS. J. 1, 10 (2011). 36. Id. at 5, 10, Id. at 25.

9 2013] TAX EXEMPTION FOR HOMEOWNERS 325 First, Anderson vastly overstates the extent to which the MFDRA benefits true speculators. Surely countless individuals bought second and third homes using exotic loan terms with the goal of quickly flipping them for a profit while housing prices escalated quickly. But congressional relief only applies to principal home residences. 38 Thus, the most irresponsible, speculative indebtedness will not be forgiven under the MFDRA. Secondly, as Congress only exempted primaryresidence indebtedness, Anderson s argument regarding unfair benefits to speculators would only be valid if most homeowners receiving such forgiveness were hardcore capitalist speculators guilty of rolling the dice. 39 Yet Anderson presents no evidence to suggest that most homeowners at the height of the bubble sought to turn a quick speculative profit on their principle personal residences. His statement of the argument suggests that any investor or homeowner hoping for eventual positive returns on their personal residence is as crazy as a penny stock investor or a roulette wheel gambler. It is far more realistic to expect that homeowners rationally sought a safe investment that would yield a positive return over time. Given that housing prices had taken seventy years to decline at historically significant rates, 40 investing in a home, even during periods of high price appreciation, can hardly be equated to rolling the dice. Homes are often Americans primary long-term investments and for good reason: they have traditionally been sound investments that appreciate over long periods of time. Therefore, little, if any, evidence exists to suggest that most homeowners obtaining COD tax forgiveness were short-term flippers or speculators. Undoubtedly, part of the rise in homeownership during the bubble has been blamed on government policies encouraging homeownership. 41 As a thought experiment to 38. See I.R.C. 108(a)(1)(E), (h)(5) (2006 & Supp. V 2011). 39. Anderson, supra note 35, at Katie Curnutte, Home Value Declines Surpass Those of Great Depression, ZILLOW BLOG (Jan. 11, 2011), See, e.g., Lucas Kawa, The Federal Housing Authority Might Be Fueling the Next Housing Bubble, BUS. INSIDER (Dec. 13, 2012, 4:13 PM),

10 326 ARKANSAS LAW REVIEW [Vol. 66:317 give the benefit of the doubt to Anderson s argument that COD forgiveness should be included in a list of blameworthy government policies, let s assume what to many is a given namely, that some of the increase in the rate of homeownership during the bubble was due to people encouraged to speculate on quick real estate profits. Still, for Anderson s position to make sense (that COD forgiveness only benefits risky speculators), he would have to first show that homeowners obtaining COD relief were the same homeowners who bought real estate primarily to speculate on quick, risky profits, rather than long-term homeowners caught up in a failing market. Anderson has not or could not make this showing. Anderson would then have to produce evidence that potential forgiveness of taxes in the case of property-value loss drove the speculators behavior. Quite simply, even if speculation was a primary driver for the increase in principal home ownership, Anderson can point to no evidence that would show that the reduction in home ownership as a result of heightened foreclosure numbers was primarily a reduction among speculators who would then unjustly gain COD tax forgiveness. Rather, in the face of skyrocketing unemployment and adjusting variable rate mortgages, it is far more realistic to assume that most homeowners were forced out of their primary residences due to economic hardship rather than homo economicus cost-benefit analysis. 42 Lastly, Anderson s argument assumes that the COD exemption is a primary driver of whether investors speculate on real estate. 43 However, Anderson presents no evidence to support this theory. Considering some commonly accepted basic behavioral science biases, it is unlikely anyone could produce such evidence. One such insider.com/fha-and-the-next-housing-bubble See, e.g., Brent T. White, Underwater and Not Walking Away: Shame, Fear, and the Social Management of the Housing Crisis, 45 WAKE FOREST L. REV. 971, (2010). White shows that many people do not walk away from their homes in a strategic default even though it would be to their economic benefit to do so. Id. If so many people were speculators and strictly economic actors, as Anderson seems to suggest, surely any homeowner significantly underwater would walk away from their mortgage and property. Id. 43. Anderson, supra note 35, at 5.

11 2013] TAX EXEMPTION FOR HOMEOWNERS 327 bias is the overoptimism bias, or the human tendency to believe that bad things will not happen. 44 Another bias is the belief that bad things happen to other people. When considering these biases in the context of a rapidly increasing market (and when combined with Anderson s lack of empirical support), it is practically inconceivable to envision an investor whose decision to speculate in real estate hinges on tax treatment of homes sold at a loss. The far more likely culprit is highlighted in Anderson s own article the fact that real estate investment profits are not taxed on primary residences up to $250, The existing literature does suggest that tax considerations can have an effect on default. 46 It is unlikely, however, that tax treatment on primary home losses somehow spurs additional speculation. B. Forgiveness Spurs Irresponsibility As a corollary to the assertion that forgiveness encourages speculation, Anderson claims that Congress s COD exemption encourages homeowners to act irresponsibly, and hope that many others do the same, because then you will receive preferential treatment. 47 Like many commentators who blame the housing crisis or its symptoms on deadbeat homeowners, 48 Anderson simply does not accept that market conditions could excuse a homeowner s responsibility to pay back a home loan. Two major problems are present in this line of thinking. First, homeowner responsibility is not just mitigated by the unprecedented market downturn. Rather, during the height of the bubble, homeowners were victims 44. See, e.g., Eric A. Zacks, Unstacking the Deck? Contract Manipulation and Credit Card Accountability, 78 U. CIN. L. REV. 1471, 1502 nn (2010); see also DANIEL KAHNEMAN, THINKING, FAST AND SLOW (2011). 45. Anderson, supra note 35, at 5 & n.10; see also I.R.C. 121 (2006). 46. Hoon Cho, Brian A. Ciochetti & James D. Shilling, Are Commercial Mortgage Defaults Affected by Tax Considerations? 25 (KAIST Bus. Sch. Working Paper Series, Working Paper No. KBS-WP , 2007), available at Anderson, supra note 35, at Marco Villarreal, Deadbeat Homeowners Causing False Sense of Appreciation in Valley, KTNV (Dec. 28, 2012), html.

12 328 ARKANSAS LAW REVIEW [Vol. 66:317 of a wide variety of intentional market distortions. It is generally accepted that appraisals were vastly overinflated. 49 Surely no serious commentator can expect an average homeowner to have been capable of combatting systematic overappraisals. Likewise, a wide variety of questionable origination practices are now known to have occurred during the housing boom. 50 Perhaps most disturbing among these practices is empirical data that shows that many homeowners could have afforded more traditional fixed-rate loans but were only offered higher rate or exotic loans and data that shows minorities were afforded differently priced credit options regardless of creditworthiness. 51 Accordingly, market conditions alone do not completely evince responsibility to repay loans, but, rather, active perpetration of overappraisals and the peddling of unnecessarily risky or high cost home loans mitigate the duty to repay. Secondly, even if the forgiveness of COD income tax encouraged social or moral irresponsibility, that forgiveness only mimics the forgiveness already given to banks. Large banks which, by many accounts, were to blame for the housing boom and bust, received billions of dollars of taxpayer money. 52 If tax relief for distressed homeowners excuses a small portion of homeowners who overspeculated and are now strategically defaulting (choosing to default even though able to pay, an arguably irresponsible or immoral action to some), that tax relief still only comprises a small portion of the tax relief afforded to homeowners. 53 When compared to the billions of taxpayer dollars directly given to an industry that has been widely lambasted for 49. S. Mitra Kalita & Carrick Mollenkamp, Judgment Call: Appraisals Weigh Down Housing Sales, WALL ST. J., Aug. 12, 2011, html ( The housing bubble that burst a few years ago was inflated, in part, by overly generous appraisals. ). 50. See, e.g., Henock Louis, Minority Lending and the Subprime Foreclosure Crisis 3 (Aug. 12, 2012) (unpublished working paper), available at com/sol3/papers.cfm?abstract_id= Id. at Crisis Mismanagement, ECONOMIST, Oct. 27, 2012, at 85, 85-86, available at See, e.g., White, supra note 42, at

13 2013] TAX EXEMPTION FOR HOMEOWNERS 329 systematic abuses that helped lead to the bust, 54 homeowners escaping some tax liability certainly seems pedestrian. Lastly, Anderson ignores the fact that congressional tax relief protected against some of the more irresponsible conduct of which some homeowners were guilty. The MFDRA did not excuse COD tax liability for any residence other than primary residences. 55 Any idea of homeowners who bought four and five properties for a quick flip benefiting from the MFDRA, therefore, is simply not in accordance with reality. Additionally, Congress specifically mandated that the only home loan indebtedness that qualifies for tax exemption is indebtedness incurred for the purpose of purchasing or improving property. 56 Second and third mortgages taken out to pay credit card debts or to buy flat-screen televisions do not qualify for COD tax forgiveness. C. Forgiveness Unfairly Favors the Wealthy Anderson argues that [t]he current exclusion of taxation on forgiven residential mortgage debt favors the wealthy and those who engaged in high stakes speculation because [a] wealthy individual receives a greater tax benefit from untaxed forgiven mortgage debt, not just in real dollars, but proportionately than a lower income individual. 57 This stems from the fact that wealthy homeowners, presumably living in more expensive homes with more sizable debt, will naturally have more debt to be forgiven. Furthermore, when that debt is forgiven, the 54. CONGRESSIONAL BUDGET OFFICE, REPORT ON THE TROUBLED ASSET RELIEF PROGRAM OCTOBER 2012, at 1-3 & tbl.2 (2012), available at See I.R.C. 108(a)(1)(E), (h)(5) (2006 & Supp. V 2011). 56. See I.R.C. 108(h)(2) (2006 & Supp. V 2011) ( For purposes of this section, the term qualified principal residence indebtedness means acquisition indebtedness.... ); I.R.C. 163(h)(3)(i) (2006) (defining acquisition indebtedness as an indebtedness incurred in acquiring, constructing, or substantially improving a principle residence); see also Mortgage Workouts, supra note Anderson, supra note 35, at (footnote omitted).

14 330 ARKANSAS LAW REVIEW [Vol. 66:317 actual tax reduction is higher for earners in high income tax brackets because they are taxed at higher rates. 58 Again, this argument suffers from framing effects and does not bear scrutiny. Framing the MFDRA as favoring the wealthy is an effective way to persuade observers who are otherwise unswayed, similar to arguing that such provisions benefit supposed speculators and people who roll the dice. Ultimately, the arguments regarding a regressive effect of COD tax forgiveness do not form a cohesive argument for ending such forgiveness. Initially, at the risk of repeating election-year debates about what level of taxation constitutes one s fair share, 59 certain facts bear repeating. In any given year over the past decade, the top ten percent of income earners pay around seventy percent of federal income taxes. 60 Forgiveness of COD income tax is unlikely to significantly increase or decrease that percentage. Thus, even if wealthier homeowners benefit more from COD tax forgiveness, that does not eviscerate the fact that top earners already pay a majority of federal income taxes. While arguments about what constitutes a fair tax burden can and will continue ad nauseum, it is sufficient for the purposes of this article to say that forgiveness of COD income is unlikely to tilt observers opinions of whether wealthy people pay a fair share. Those who reflexively look to tax higher earners will 58. See I.R.C. 1(c) (2006). To rephrase and simplify an example given by Anderson, consider two homeowners: one in the thirty-five percent income tax bracket and one in the twenty-five percent bracket. A $10,000 COD incomegenerating event would generate an additional $2500 in taxes to the twenty-fivepercent earner and $3500 to the thirty-five-percent earner. Thus, because wealthier homeowners stand to pay a higher tax rate on their COD income, they will also save more when Congress forgives the tax. The wealthier homeowner in our example saves $3500 in tax liability, whereas the twenty-five percent earner saves only $2500. Anderson, supra note 35, at See, e.g., Reid J. Epstein, Obama Hits GOP on Bush Tax Cuts, POLITICO (July 28, 2012, 7:03 AM), ( [Republicans] believe that if our country spends trillions more on tax cuts for the wealthy, we ll somehow create jobs.... ); Ronni Mott, Who Are the 47 Percent?, JACKSON FREE PRESS (Oct. 2, 2012, 11:38 AM), news/2012/sep/26/who-are-47-percent/ (discussing Mitt Romney s controversial comments about the forty-seven percent of taxpayers who pay no income taxes). 60. Who Pays Income Taxes and How Much?, NAT L TAXPAYERS UNION, (last visited Jan. 31, 2013).

15 2013] TAX EXEMPTION FOR HOMEOWNERS 331 always be against tax relief, whether in the form of COD forgiveness or otherwise. Those who reflexively support tax cuts of any type will never mind whether wealthier Americans benefit more from such cuts than lower earners. Anderson also suffers from the unfortunate tendency to view tax relief as a zero-sum game. He asks the rhetorical question, If the goal of Congress was to help the downtrodden, then why not place some reasonable middle class income caps on the tax exclusion rather than the upper class caps? 61 The problem with this line of thinking is twofold. First, lower class homeowners will neither be helped nor harmed by the large caps. It is economically irrelevant to an individual homeowner whether someone else benefits from the COD exclusion. In other words, a wealthy homeowner does not steal a tax exclusion from someone else; rather, people benefit independently of whether others gain from the exclusion. Secondly, Anderson appears to assume that no justification exists for relief for any group other than the downtrodden. 62 However, many reasons exist to justify tax relief on COD income for income earners of all levels. These justifications, which will be discussed further, include, among other reasons, avoiding incentives to file for bankruptcy, avoiding disincentives to seek loan modifications, removing barriers to allow distressed homes to enter the market, and allowing some form of relief to homeowners taken advantage of by predatory lending and inflated property values. 63 These arguments are not income dependent. Rather, a case can be made that each of these justifications are valid regardless of the homeowner s income. Accordingly, Anderson s argument that the extension of the MFDRA is unjustified on grounds that it benefits wealthier taxpayers more is unconvincing. 61. See Anderson, supra note 35, at Caps, in this context, refer to debt forgiveness limits. See I.R.C. 108(h)(2) (2006 & Supp. V 2011). 62. See Anderson, supra note 35, at See infra Part IV. A.-C.

16 332 ARKANSAS LAW REVIEW [Vol. 66:317 D. Horizontal Inequity Another anti-forgiveness argument is that the tax forgiveness of the MFDRA violates horizontal equity considerations the need to treat similarly situated taxpayers consistently. 64 Some have argued that the MFDRA violates horizontal equity because it only forgives tax from COD income during certain tax years. 65 Anderson further argues that this violates moral considerations, as the bizarre tax free zone constitutes the pinnacle of individual favoritism. 66 This argument, taken to its logical end, is an inadequate criticism of the particularities of the MFDRA s forgiveness. First, consider the criticism that forgiveness is unfair to taxpayers who paid COD income taxes in previous years. 67 This argument could be made for an infinite number of tax law changes. By this dubious reasoning, any addition, deletion, or modification of credits, rate cuts, deductions, or other provisions of the Code are immoral and improper as violations of horizontal equity. Does the taxpayer who sees his income tax rate cut ask Congress for a refund of the taxes paid at the higher rate in previous years? It is an interesting thought experiment, but altogether irrelevant, to discuss the disparity in treatment towards previous taxpayers. The primary concern in evaluating the MFDRA should be whether the forgiveness achieves its goals and whether those goals are worthy enough to justify forgiveness. Unfortunate though the situation might be for previous taxpayers who paid COD income tax, they are no more unfortunate than those who paid higher sales taxes in one year only to have those taxes lowered in the next. Furthermore, even if the unfortunate plight of previous COD taxpayers did create some sort of moral quandary, tax treatment has long been influenced by temporary market conditions. The Great Depression triggered judicial opinions interpreting and expanding the insolvency 64. Anderson, supra note 35, at Id. at Id. at Id. at 16.

17 2013] TAX EXEMPTION FOR HOMEOWNERS 333 exception to COD income so as to keep companies out of bankruptcy due to market conditions. 68 Likewise, part of the stimulus package granted tax credits to spur the economy. 69 These credits included, for example, first time homebuyers receiving a new tax incentive to purchase homes. 70 The point is not that such temporary tax alterations are the best policy, but that such tinkering is not new and is not a uniquely negative aspect of the MFDRA. Finally, anti-forgiveness arguments based on a lack of horizontal equity ignore the fact that the Code already treats certain loan indebtedness differently. For instance, forgiving non-recourse loans upon surrendering a property does not subject the beneficiaries of such forgiveness to COD income tax. 71 Non-recourse loans are more likely to constitute business debts; therefore, the Code already treats similarly situated borrowers differently. Singling out one class of debtor for forgiveness or unique tax treatment then is not a novel concept and does not invalidate the positive effects of the MFDRA. E. The Exception Is Not Necessary in Light of the Insolvency Exception One of the major arguments Anderson asserts is that the MFDRA was unnecessary in light of the already existing insolvency exception to COD income taxation. 72 In particular, Anderson argues that the insolvency exception is sufficient because it can be utilized without the need for a bankruptcy filing and because restricting forgiveness to insolvent debtors would prevent otherwise-solvent strategic defaulters from using the MFDRA s exception. 73 However, this argument fails to recognize two major disadvantages of the insolvency exception. First, the insolvency exception only acts as a deferral of COD income 68. See Armstrong, supra note 13, at The American Recovery and Reinvestment Act of 2009: Information Center, INTERNAL REVENUE SERVICE, (last updated Aug. 21, 2012). 70. Id. 71. Deborah A. Geier, Tufts and the Evolution of Debt-Discharge Theory, 1 FLA. TAX REV. 115, 140 n.72 (1992). 72. Anderson, supra note 35, at Id.

18 334 ARKANSAS LAW REVIEW [Vol. 66:317 tax liability. 74 Accordingly, even insolvent homeowners may eventually owe taxes on COD income. 75 Secondly, the insolvency exception s calculation of assets and liabilities mandates that taxpayers take their bankruptcy exempt assets into account, including retirement savings. 76 Finally, the insolvency exception may only apply for the most financially desperate of homeowners who are not able to afford a loan modification. This stems from reasoning that suggests that those who can afford a modification must not be completely insolvent. 77 The insolvency exception, therefore, would not prevent taxation on significant loan modifications. 78 Such taxation, in the absence of the forgiveness provisions of the MFDRA, could be a significant impediment or disincentive towards restructuring loans. 79 Thus, the insolvency exception does not completely protect homeowners against owing taxes on COD income. 80 Anderson s assertion that the insolvency exception alone would be sufficient to protect homeowners from the downturn in housing prices, therefore, is not entirely correct. IV. THE CASE FOR FORGIVENESS Although several commentators have argued against COD income tax forgiveness for homeowners, no comprehensive scholarly examination has expressed the case favoring such forgiveness. Accordingly, having explored the weaknesses in anti-forgiveness arguments, this Part discusses the reasons for extending forgiveness for primary-home loans: to disincentivize the filing of personal 74. Hochbein, supra note 17, at 917, Id. at The Housing Decline: The Extent of the Problem and Potential Remedies: Hearing on H.R Before the S. Comm. on Fin., 110th Cong. 7-8 (2007) (statement of Deborah A. Geier, Professor of Law, Cleveland-Marshall College of Law), available at Robert M. Lawless et al., Did Bankruptcy Reform Fail? An Empirical Study of Consumer Debtors, 82 AM. BANKR. L.J. 349, 377 (2008). 78. John E. Capps, Note, In the Wake of Cottage Savings: The Tax Consequences of Debt Modifications, 72 TEX. L. REV. 2015, 2020 (1993). 79. Id. at See id.

19 2013] TAX EXEMPTION FOR HOMEOWNERS 335 bankruptcy, to remove impediments to seeking loan modifications, and to hasten the resolution of the housing downturn. A. Disincentivizing Bankruptcy The paramount reason for extending forgiveness to homeowners is to disincentivize the filing of personal bankruptcies. As a matter of public policy, the Code should generally encourage private workouts rather than personal bankruptcies. The following realistic scenario in the absence of the MFDRA describes how bankruptcy can look appealing in the face of COD income tax liability. Suppose Homeowner Smith purchased a modest house during the ascent of the housing market in the early 2000s for $200,000. Due to reduced hours at work, he is unable to afford his current payments on the home which is now worth only $100,000 and he has not qualified for a loan modification after submitting his financial documentation to his loan servicer five separate times. Smith, now despairing at his ability to obtain a loan modification, appeals to his loan servicer to simply take back his property in exchange for an agreement to waive any right to collect on a potential deficiency judgment. His lender agrees, giving him 120 days to vacate the property. Now, assuming the MFDRA had not been enacted or extended, with the final settlement paperwork in front of him, Smith must consider the following two options. Option One: Smith can sign the paperwork, and his deficiency of approximately $100,000 (the amount the property is underwater ) will eventually be reported by his lender on a 1099 form as cancellation of debt. He will owe ordinary income tax on that amount in the coming tax year. Given his income tax bracket, he estimates that the taxes he will owe will be $25,000. Concerned about his potential tax liability, Smith consults with an accountant. The accountant explains that Smith may qualify for deferral of the $25,000 in taxes if he can demonstrate insolvency. Unfortunately for Smith, he has been a reasonably prudent investor and has a sizable

20 336 ARKANSAS LAW REVIEW [Vol. 66:317 sum set away in retirement accounts. These retirement accounts, his accountant explains, must be considered when balancing his assets and liabilities in determining insolvency. The retirement money pushes Smith s balance sheet into the black, so he is not insolvent under the Code. Thus, because Smith cannot show insolvency due to his prudence, he faces the prospect of a tax penalty on early withdrawal of his retirement funds in order to pay the $25,000 in taxes potentially due next year. Irked by the seemingly impossible situation in which he finds himself, despite his prudence and planning, Smith suffers a mid-life crisis, sells all of his worldly goods, and lives out his days in a monastery in Bhutan. Option Two: Alternatively, Smith can file a Chapter 7 bankruptcy to attempt to have all of his debts discharged. Smith consults with his attorney, who explains that by refusing to settle with his loan servicer, he can avoid owing any COD taxes by declaring bankruptcy. This will cost only $2,500 in legal fees, and after a few months, Smith will obtain a discharge. He will then owe nothing further and will not have to worry about his retirement accounts, which skate through the bankruptcy process unscathed. 81 Not only that, his attorney tells him, but because Smith lives in a judicial foreclosure state, Smith will be able to live in his home for an extended period of time without paying his mortgage before he is even forced to file bankruptcy while the foreclosure process winds through the courts. 82 Filing a bankruptcy will automatically stay the foreclosure process for a few months when Smith is sure he wants to move. 83 Relieved, Smith returns home, happily lives in the property without paying his mortgage for three years, and then files for bankruptcy the day before the foreclosure auction, gaining at least three more months to live in the home. He obtains his bankruptcy discharge in federal court and owes no debts or taxes. Exceedingly happy with how 81. See 11 U.S.C. 522(b)(3)-(4) (2006 & Supp. V 2011). 82. See Karen M. Pence, Foreclosing on Opportunity: State Laws and Mortgage Credit, 88 REV. ECON. & STAT. 177, (2006). 83. See 11 U.S.C. 362 (2006 & Supp. V 2011).