The next debacle - taxes after the mortgage mess

60 Minutes had an interesting piece (below) on the low-end of the mortgage crisis - (1) borrowers bought houses with no money down (and often with cash back), (2) lenders, brokers and everyone else pushed them to do it because commissions were based on the close of the transaction, and now that home prices are falling (down 21% YoY in the Bay Area for the bottom third of home values), and (3) buyers, unable to sell or refinance since they now owe more than their home is worth, are defaulting (with >$1B of homes in foreclosure just in Stockton, CA). All the losses get triggered on the banks' books because the debt gets downgraded, so the value of the CDOs (collateralized debt obligations = pools of mortgages) they carry plummets and they take those losses now.

S&P estimates more than $265B of total losses from the CDO write downs. That's a huge mess.

The next mess is how all of that wreaks havoc on the tax system:

1. People who short sell (sell for less than their mortgage(s)) or have their homes foreclosed owe money to the IRS (and their state) in two ways - (1) they may have gain on their house. Even if they get foreclosed and they owe more than the house is worth (because of home equity lines or refinancing), they could still be "selling" for more than they paid. That's capital gain, but on a primary residence most people (in these circumstances) can exclude it for tax purposes; (2) if the mortgage company doesn't collect all of the loan, the part they "forgive" counts as income. So a $300K mortgage on a house that's short sold for $200K, generates $100K of taxable income for someone who's in the $50K range on annual salary (even worse, it puts them in a higher tax bracket) - so they might owe $35K of tax on the loan forgivenes, even though they have no money to pay. The tax liability gets forgiven if they go bankrupt or insolvent. (So maybe the "best" plan is to run up tons of other debt and make sure the tax liability pushes you into insolvency!) In most cases, the IRS will never be able to collect, but they're going to try and it's going to give a lot of people heartburn. It's a good time to be a low-end tax attorney. This is a major personal tax problem for the people in the 60 minutes segment who can pay but just think paying doesn't make sense - the IRS will collect in that case. (Maybe they prefer to give their money to the government than to the bank.) It's not much of a federal tax problem by not collecting, since the government never anticipated that money as income (except for point 2 below). Of course, if the government just bails people out of it by waiving the cancellation of indebtedness provisions, most of us will never work for salary again - we'll just have our companies loan us money and forgive it later. It's definitely income (the 60 Minutes segment describes people who have spent proceeds from the forgived loan, just like they would spend any other income), so it seems fair to tax it.

2. The Federal government loses on the tax writeoffs that the banks with $265B in losses are taking. At the corporate tax rate, that's about $70B in lost taxes to the feds (some of it's foreign held, etc, but putting tha aside...). This is why the forgiveness in point 1 gets taxed - because the act of forgiveness is a writeoff for the person doing the forgiving. They could just not allow it to be a writeoff anymore so that the banks pay, but then you can bet the banks will then work harder to collect on short sales. Credit would also get a lot tighter. There's no easy fix, so here's $70B (minus whatever they collect in tax revenue from individuals in point 1) lost to the federal government.

3. The states are the big losers. They lose a lot of property tax revenue - not just 1% * $265B per year because most home values are falling - so people can get their homes re-assessed whatever their financial status. It doesn't matter whether they move, get foreclosed, stay put, whatever. This is an annual shortfall, and it may be quite awhile before home values get back to where they were - so states will have less money for quite awhile. Of course, when they budget, they don't plan for that, so there will be a bunch of state budget crises for the next several years because of the mortgage mess. Cleveland and Baltimore are even suing over the lost tax revenue. (They're not giving back the excess tax revenue they earned from builder taxes, payroll taxes, or proerty taxes while the "defective loans" were being made, so I'm not sure their suit is exactly symmetric, but they have interesting arguments.)

Although it's painful, and unfair if there was predatory lending involved, I think it does "make sense" that they have to pay their mortgage even though their house declined in value. It is what they agreed to do (if they can't then bankruptcy is an alternative, but they say they can.)

Banks are going to raise borrowing costs for people who walk away (and probably for everyone else), so we'll all be forced to live within our means. Not necessarily a bad thing, but it sure doesn't bode well for consumer spending! (HELOCs are already getting shut down.) The tax issues are going to clamp down state spending, and the federal government is already in deficits.

From basic macro, GDP = consumption + investments + government spending + net exports.

GDP and government spending are headed down. Time to find something recession proof to do.

Technorati: mortgages, subprime, recession, taxes