Mortgage rescue plans ignore tax consequences

Long Island Business News, Oct 24, 2008 by Mark Singletary

The world is full of unintended consequences, and it's time the presidential candidates started thinking about them.

The subject, my friends, is debt relief - and the unintended consequences might be a huge tax bill for the unburdened debtors.

In separate statements at two debates, Democratic vice presidential candidate Joe Biden and Republican presidential candidate John McCain may have overloaded their benevolence with ignorance.

First of all, forgive me when I delve into accounting and economic theory. I know deep in my heart many Americans don't like to hear, much less read, about bookkeeping, but it is important. As it turns out, it might become very important to many troubled homeowners.

Biden and McCain have outlined proposals for troubled homeowners that sound generous. Biden wants bankruptcy judges to have the power to set aside or restructure mortgage debt. His theory is that upside- down borrowers can stay in their homes if their debt more properly reflects the current market value of their property and their ability to repay their loans.

McCain's proposal is even more radical.

President McCain would sweep in with $300 billion or so of our money and start buying bad loans from banks and other mortgage lenders.

His theory - again very populist on the surface - is that the federal government can wipe away the excess value of these mortgage obligations and reduce principal balances to a more current and manageable market basis.

The feds would then, presumably, sell the mortgage papers on the open market and take the proceeds and do it all over again until everyone who has a mortgage is happy.

Both of these proposals sound compassionate. Both of these proposals might slow foreclosures. And both of these proposals might create more harm than good.

The harm comes from Accounting 101 principles and our existing federal tax code. The basis of all accounting is balanced double- entry bookkeeping. For every debit, there is a credit. The humble T- account is the basic element for reflecting the proper statement for all financial transactions. As far as I know, there are no exceptions.

Assets equal liabilities plus owners' equity. Owners' equity is positive when net assets are greater than net liabilities, and sadly equity is negative when the opposite is true whether for huge corporations or individual taxpayers.

When I borrowed money to buy a home, I created a liability and an asset for myself, and the bank I borrowed from created a new asset and reduced the value of another. My liability reflects a promise to repay the loan, according to the terms agreed to when the loan documents were approved and signed. I also have an asset based on the current market value of my home.

Consequently, the bank's accounting records reflect a new asset (the loan) and a future income stream (the interest) for its part of the mortgage transaction. The corresponding or balanced entry on the bank's balance sheet is a reduction of cash, a current asset.

Everything is in balance; all is right with the world.

However, if I choose not to pay back my loan, a foreclosure occurs and the property is sold for a loss. The bank must recognize the loss, and I am liable to the IRS for taxes on the difference between the disposal price of the asset (my home) and the net realized value. The gain, although hard to imagine, creates a tax liability for me.

Yes, the IRS is the interested third party when debts are forgiven. As proposed, the Obama-Biden Bankruptcy Intervention Plan and the McCain Throw Out the Inflated Mortgage Plan would create significant tax gains for the affected borrowers.

That taxable gain is the unintended consequence that neither candidate has talked about. Sadly, I haven't heard a single question raised on the issue either.

One might ask how this can happen without Congress amending the IRS code to do away with the taxes on these gains? Well, for one thing the president has a bully pulpit to do most everything he wants to do. Executive orders are powerful and very dangerous to ignore.

Rewriting the tax code is a complicated process. The next president has to persuade Congress to amend the relevant IRS codes to wipe away accounting principles and tax laws that maintain balance, and that have been a part of the law for decades, for this to work.

Fat chance that happens and, once again, unintended consequences rule the day.

This story appeared in sister publication New Orleans City Business.