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

Abstract

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 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 purchase-price exemption would provide homeowners with incentives to renegotiate their home loans or to negotiate walkaways rather than filing for bankruptcy.

Keywords: mortgage, subprime, housing crisis, foreclosure, bankruptcy, cancellation of indebtedness, income tax