If the politicians in Washington today were instead the CEOs of private industry, they’d all have been fired by now.” Anonymous [sort of]
Introduction. At the end of 2012 we all went over the Fiscal Cliff like Wile E. Coyote. But unlike Wile E., we were able to grab a hold of a small scraggly branch on the way down, and eventually climb back onto terra firma…for the time being. The next looming crisis – the Debt Ceiling negotiations – is the second feature in this macabre satire called “Your Government at Work,” so don’t go away just yet![1]
Leaving a discussion of who’s to blame for another day [there’s enough blame to go around], how did the real estate industry fare in the Fiscal Cliff legislation [technically known as H.R. 8, American Taxpayer Relief Act of 2012], that was moved, seconded and passed on January 2, 2013? Well, considering what was at risk, it appears we dodged a few bullets, albeit temporarily. So here’s what the scorecard looks like right now:
1. The Mortgage Interest Deduction. This sacred cow was in the cross-hairs. Although it was likely mostly talk, my concern is that it was actually a “trial balloon” to evaluate public and political sentiment for more serious discussions later this year. And of course, with the White House’s insistence that the “rich” – whatever that means today – “pay their fair share,”[2] there was some concern that taxpayers at a certain income level would be sacrificed at the altar of class warfare. That did not happen with the interest deduction, thanks in large part to the strong lobbying efforts of the National Association of REALTORS® coupled with the commonsense belief that housing could ill-afford another body blow coming so soon after five years of pummeling on the ropes. As housing goes, so goes the economy, and it’s a very good thing that the mortgage interest deduction was left fully intact.
According to a recent Bloomberg article here, “Homeowners will save about $100 billion this year from mortgage interest deductions, according to Compass Point, helping to make buying more affordable relative to renting.”
2. The Mortgage Insurance Deduction. Mortgage insurance (“MI”) has historically been required for borrowers whose down payment is less than 20% of their home’s purchase price. If they have only 5% down, MI is required to fill the 15% gap. This means that if the borrower defaults, the MI carrier pays the lender for the amount insured. It was a useful and necessary aid that permitted home buyers to obtain conventional loans, even though they did not have the requisite 20% down payment.
But during the easy money years, circa 2005-2007/8, many purchasers found that they did not need mortgage insurance to buy a home – thus avoiding the additional payment of a monthly insurance premium to the MI carrier. Instead, with the aid and assistance of lenders and mortgage brokers, borrowers were offered an array of risky financial products, such as “piggy-back” loans, that permitted the necessary additional funds for a down payment to simply be added on to the back of an 80% first loan. In many instances, borrowers never paid any down payment, and instead were able to obtain an 80% first mortgage and a 20% second. These loans were primarily sold by lenders into the “private label secondary market[3]” – not to the Government Sponsored Enterprises, or “GSEs”, Fannie and Freddie. Between the drop in mortgage insurance demand [in favor of piggy-back loans], coupled with the increase in claims made by banks under their existing MI policies, insurers found themselves awash in red ink.
Unfortunately, when financing options collapsed in 2007-2008, bringing real estate down with it, many borrowers realized that they could not really afford to service two loans – especially when so many of them adjusted from low “teaser” rates to much higher interest rates. These loan programs were largely the result of poor or non-existent underwriting decisions by the banking industry coupled with a universal Pollyana-ish belief that real estate prices would never go down. And since property values plummeted, refinancing out of these bad loans became impossible, since borrowers had no equity.
Now, fast forward to today, as we try to dig out from a bruised and battered economy; there really is no viable private label secondary market – that was where folks who either could not afford, or did not want to pay, 20% down, gravitated. Today, the only players in the secondary market are the GSEs. Yet Fannie and Freddie today require that borrowers of conventional [i.e. not FHA, DVA, etc.] loans either have a 20% down payment or secure mortgage insurance. For millions of other Americans who have FHA loans, Federal and State V.A loans, they also pay MI premiums.
Until 2011, mortgage insurance premiums were deductible, much like the interest payments on one‘s home mortgage. With the Fiscal Cliff legislation, not only are the insurance premiums again deductible, but the change is retroactive to 2012 – so long as the homeowner makes less than $110,000 per year. This is an important benefit for those folks who secured mortgage insurance on their loans after 2008 [following the disappearance of the private label market], and the re-emergence of Fannie and Freddie as the dominate purchasers of conventional loans. According to the Bloomberg article [relying on an industry press release]: “Almost 3.6 million taxpayers claimed the deduction for mortgage insurance in 2009, the most recent year for which Internal Revenue Service data is available. They deducted almost $5.5 billion in premiums, for a total tax benefit of more than $700 million, according to the National Association of Homebuilders in Washington.”[4]
3. The Cancellation of Debt Exemption. In 2007, with the foreclosure crisis budding, but not yet in full bloom, it became apparent that there was going to be an avalanche of mortgage defaults which could only end in one of four ways: (a) Loan modification[5]; (b) short sale; (c) deed-in-lieu-of-foreclosure (“DIL”); or (d) foreclosure. Options (b), (c), and (d) invariably resulted in the bank cancelling a portion of the borrower’s debt. Under certain circumstances where there was a material modification, option (a) could also result in debt cancellation.
Under the Internal Revenue Code, cancellation of recourse debt[6] is generally taxable, just the same as income. [See detailed discussion here.] This meant that for the millions of borrowers who defaulted because they could no longer afford their mortgages, they could have the unpleasant surprise of receiving a Form 1099-C in the following tax year, telling them and the IRS, that the cancelled debt would be treated as the receipt of income. Of course, it was actually “phantom income” – the kind you have to account for, but never had the pleasure of earning or spending.[7] Accordingly, the Mortgage Forgiveness Debt Relief Act was passed in late 2007. Essentially, it said that (a) if the loan was used to buy, build, or substantially improve the primary residence, and (b) the borrower owned the home for at least two of the last five years, it would not be taxable as ordinary income.
This law had been scheduled to disappear in 2010, but was extended to December 31, 2012. However, it was clear throughout 2012 that given the remaining numbers of distressed homeowners in, or on the cusp of default, the Act needed to extended. Clearly, there were still thousands, if not millions, more homeowners, who would be negatively affected if they suffered a “1099-C event” in 2013 or thereafter. However, rather than lift a finger to assuage the fears of these homeowners, Washington ignored the issue, leaving the public in doubt. It was not until the Fiscal Cliff legislative deal was finally worked out on January 2, 2013, did we learn that the cancellation of debt exemption had been attached – almost as an afterthought – to the omnibus bill.
Whether it will be extended beyond this year is a question that will probably not be answered until we have another “Cliffhanger” at the end of 2013. In my opinion, there is some risk that an extension will not occur. Much depends on how well the economy in general [including unemployment], and real estate in particular, performs. It is entirely conceivable that the exemption will not be extended. It is for this reason that I have been preaching the short sale mantra, since it is the only solution of the four options (a) – (d) that can occur relatively quickly.[8]
4. Energy Efficiency. Tax credits up to $500 for home energy improvements [e.g. cooling and water heating appliances, insulation, windows and doors, energy efficient heating, etc.] lapsed in 2011. They have been revived for 2013. Remember this is a tax “credit” not a tax “deduction.” The difference is that the former is a dollar-for-dollar credit against your tax bill. That hits the bottom line.[9]
5. Capital Gains Rates, Etc. The Fiscal Cliff legislation did not change the 1986 capital gain rules dealing with the sale of a primary residence owned for two of the last five years. For single filers, they do not have to recognize up to $250,000 in capital gains on the sale of their home; for joint filers, the exclusion rises to $500,000. Of course, in order to take advantage of the gain exclusion, one must have “equity” – that unique feature of home ownership that disappeared for millions of Americans over the last five years.
The capital gains rules become a mixed bag beyond that. For higher income home sellers [i.e. $400,000 for single filers and $500,000 for joint filers] the rate will be 20 percent on the excess over the 250,000/$500,000 exclusion, rather than the preexisting 15 percent rate. Earners at the two lowest tax brackets will pay nothing on their capital gains.
In addition, Congress revived some of the Pease limitations, a 1990 Draconian law bearing the name of its sponsor, that targets higher income earners by reducing the benefit of certain itemized deductions.[10] For 2013, those taxpayers filing jointly with an adjusted gross income exceeding $300,000 [or $250,000 filing individually], the limitations will kick in. They will apply to (a) charitable contributions and, (b) mortgage interest, state, local, and property deductions, including certain other miscellaneous itemized deductions. The formulas are a bit complicated. For a more detailed discussion, go to the link here. The Pease limitations do not apply to medical expense deductions.
Conclusion – Are We Merely Following The European Model of Dysfunction? Most sequels are worse than the original. We shall see as this play plays out with the Debt Ceiling negotiations. And yet, we’ve seen this movie before – well, actually a very similar movie – that is already playing out before us called “The crisis in Euro zone.”
Fiscal mismanagement is a failing that seems to be a uniquely reserved to politicians on both sides of the Atlantic. Normal mortals do not have the luxury of deficit spending or accounting gimmicks to fill other gaps in their balance sheet.[11] If politicians were in the private sector, they would have been fired on the spot – which explains why they are in the public sector in the first place – where The Peter Princple thrives. And voting the pols out of office is not the answer; they will merely be replaced with new fiscal zombies, more concerned with their political future than the welfare of those who elected them.
In a recent Washington Times opinion piece, authored by Mike Lee, the Republican senator from Utah and a member of the Joint Economic Committee, he observed:
“If our failure to make significant structural changes in government spending leads to borrowing conditions like those of Greece, we could experience a meltdown of the financial markets and broad economic upheaval from which we may never recover. Such circumstances would require massive and immediate cuts to Social Security, Medicare, national defense and virtually every discretionary program to avoid a credit default.
Most Americans will find this scenario difficult to believe, but make no mistake — if we do nothing, the avalanche will break suddenly and without warning. As Harvard economist Kenneth Rogoff recently explained, “By the time [markets] lose confidence, it’s too late: The option to tighten from a position of strength has evaporated.”
President Obama says his solution to our deficit and debt is to raise taxes on the very wealthy. His approach does almost nothing to address the structural spending challenges we face. Over 10 years, the president’s most recent budget, which includes his tax hike, still adds almost another $11 trillion to the national debt.
***
What our country needs most is fiscal restraint, structural spending reform and sound economic policy to promote investment and jobs. Simply continuing to kick the budget can farther down the road will make these required reforms increasingly more difficult and ultimately more painful. Such continued delay risks arriving at a point when we no longer can borrow and we have no choice but to painfully slash government spending overnight.
Is Washington up to the challenge? So far, the answer has been no. That must change soon. If the fiscal avalanche breaks before we change course, the result will be disastrous.”
Perhaps Mr. Lee should put a finer point on his message: The real danger of fiscal cliff diving is that there is no safety net.
[1] Note, however, there are some who argue that all this debt ceiling hand-wringing is a canard, i.e. a red herring, intended to vilify those Republicans holding firm for spending cuts rather than increased taxes. For an interesting and eye opening discussion, see the recent article in The Wall Street Journal’s opinion page, here. And in the Economist online: “From Cliff to Ceiling – The debt ceiling in America serves no useful purpose and should be abolished.”
[2] I do not take this charge lightly, as it suggests that those at certain income levels do not already pay their “fair share,” i.e. they are not net contributors to the American economy. In other words, they take more than they give. Riddle me this, Batman: Where do the thousands of dollars in federal income taxes, state income taxes, city business taxes, property taxes, and payroll taxes [or self-employment taxes] go, if not to the betterment of the country as a whole? On the debit side of the taxpayer’s ledger, these taxes represent a significant amount of money. So what is this taxpayer taking out of the nation’s coffers? If he or she is not receiving some form of government help through an entitlement program [I’m excluding Social Security, since these monies were already paid by the taxpayer into a trust fund that guaranteed repayment. – PCQ] doesn’t this mean that the taxpayer (a) is not using government services any differently than any other citizen, taxpayer or not, and (b) is thus a net giver – not a net taker? If this is correct, then what does it mean to accuse any such taxpayer of not paying their “fair share”? In truth, this polemic appears to be more of a political ruse, designed solely to inflame class warfare – and secure votes.
[3] During this time, there were two major “secondary mortgage markets” that bought loans from the lenders that originated them: One consisted of the Government Sponsored Enterprises, or “GSEs”, Fannie and Freddie and to a lesser degree, Ginnie Mae. The other purchaser of housing loans was the “private label market.” It worked in much the same way as the GSEs, except that its lending criteria was much, much lower. In both cases, the loans that were purchased were assembled into huge loan pools [a process known as “securitization”], and sold to investors throughout the world. In the case of the GSEs, investors purchased slices [called “tranches“] of these pools because they were believed safe, having the “implied” guarantee of the federal government. Investors also purchased interests in the private label market, because most were given “investment grade” ratings by the big ratings agencies, S&P, Moody’s and Fitch. It was not until 3Q 2007 that the ratings agencies decided, in unison, that the formerly highly rated securities were “junk.” The resulting collapse of the private label secondary market was nearly immediate, and continues to this day.
[4] This law also served as a lifeline to the MI industry as a whole, as it reeled from the loss of business circa 2004-2007, and lender claims, due to the swelling defaults and foreclosures.
[5] I am not including refinancing, since it only worked [initially], if one had equity. Before HARP and similar federal programs, the only way one could refinance their home if they had negative equity was to bring money to the closing table. This was an option available to very few.
[6] “Recourse debt” is debt that a lender has the ability to recover against the debtor – i.e. their recourse is not limited exclusively to the property secured, e.g. the home. “Non-recourse” debt means the creditor’s sole means of recourse in the event of default, is to recover back the security. Cancellation of “non-recourse” debt is not a taxable event, since the borrower has no personal liability for repayment.
[7] In normal times, the law does make sense. If you loan me $5,000 today, and you tear up my promissory note tomorrow, I am $5,000 to the good. But that concept gets tipped on its head when the borrower defaults due to an inability to repay. If one cannot afford to repay a debt, how will they afford to pay the tax resulting from cancellation? With millions of Americans in this position, Uncle Sam would have a hard time justifying taxing homeowners on their default events [e.g. short sales, DILs and foreclosures], thus making money on every struggling homeowner’s misfortune.
[8] Banks typically will not accept a DIL until after the homeowner has tried unsuccessfully for several months to short sell their home – and even then, DILs are not always approved, especially if the homeowner is already facing imminent foreclosure. This puts DILs behind short sales, in terms of timing. The foreclosure event will occur sooner or later, by virtue of nonpayment; but for homeowners who are still current on their loans, but just barely, payment default commenced today would not likely result in a completed foreclosure by December 31, 2013. The loan modification process is more akin to a macabre kabuki dance, than anything remotely helpful for most borrowers. That is why it has been derisively referred to in lending circles as “Extend and Pretend.” In any event, the risk of attempting modification today is that it can put the homeowner into the position of being denied say, in October, 2013, and not being able to commence and close a short sale transaction before the end of the year.
[9] There is much more – up to $2,000 in credits – pertaining to “…contractors or developers that construct or significantly renovate ‘dwelling units’ (apartments, condos or single-family homes) that meet certain energy efficiency standards.” See good discussion at the law firm link, here.
[10] The rationale, which illogically – in my opinion –disincentivizes such things as home ownership, is based upon the incongruous theory that, “By Golly, higher earners are the primary beneficiaries of these deductions, so let’s reduce the benefit to them!” This, of course, is nonsense. Everyone who itemizes their deductions benefits from them. Until recently, perhaps, home ownership was regarded as “The American Dream” and a goal of wage earners of all stripes. If only one to two percent of earners are in the $250,000/$300,000 AGI category [I don’t know this to be the case], then 98% – 99% of all other taxpayers who own a home benefit from the deductions if they itemize them. Presumably, they would not itemize if their tax liability was less, or their refund more, by doing so. In short, those higher earners numerically comprising 1%-2% of the taxpaying population don’t disproportionately benefit from the use of these deductions; they’re just easier targets because in a one-person-one-vote democracy, their say is proportionately less important and less vocal. And what about charitable giving? Won’t the Pease limitations hurt the receiver more than the giver? For a discussion of that issue, go to the Forbes link here. In an interesting analysis, the author claims that with higher tax rates, charitable giving in 2013 is worth more, not less, than in 2012!
[11] For an interesting European analysis, see the following article in the well-respected Economist – a British publication – titled “America’s European Moment – The troubling similarities between the fiscal mismanagement in Washington and the mess in the euro zone .”
