Eminent Domain Scheme Has a Tax Problem

James Greiff is an editor for Bloomberg View. He was Wall Street news team leader at Bloomberg News and senior editor for Bloomberg Markets magazine. He previously reported on banking for the St. Petersburg Times and the Charlotte Observer.
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There's been plenty ofcarping about the plan by Richmond, California, to use eminent domain to seize mortgages and, with the help of the investment firm Mortgage Resolution Partners, lower the loan principal for more than 600 homeowners who owe more than their homes are worth.

Aside from the complaining by banks and investors that it's unconstitutional, unfair and will kill off new mortgage lending, there's one issue that hasn't gotten as much attention: Taxes, and how some think they make the plan unworkable.

The short story is that when a lender forgives all or part of a debt, as called for in the Richmond plan, the borrower incurs a tax liability. This represents the difference between the original amount borrowed and the lower amount that the lender has agreed to accept as repayment.

The reason is pretty simple. When someone is granted a loan, the money they receive isn't counted as income even though it functions as if it is. When debt is forgiven, though, that does represent a transfer of wealth to the borrower, so tax is owed. The Internal Revenue Service lays it all out in language about as clear as one could expect from everyone's favorite bureaucracy.

There are some exceptions. Someone who files for bankruptcy and has his debt either wiped out or reduced is exempt. It's also true when someone is declared insolvent (when debts exceed assets). Certain farm debts can also be reduced without tax consequences.

The one other case involves so-called non-recourse loans, where the lender can only foreclose or repossess the property, not go after a borrower's other assets. This doesn't cancel the debt, and doesn't necessarily trigger a tax. Some states don't allow loans like these, though California does. Of course, this may not keep people in their homes.

This ismessy stuff. But there may be another, more clear-cut tax haven for Richmond's underwater homeowners.

Debt forgiveness emerged as an issue in the waning days of the George W. Bush administration, which wanted to help out millions of borrowers as the U.S. real-estate market crashed. In 2007, Congress passed legislation granting tax exemptions to homeowners who received principal writedowns through the end of 2012.

Luckily for homeowners still underwater who didn't make the 2012 deadline, along came the fiscal cliff and its package of expiring tax breaks and spending cuts: Congress has a soft spot for real estate and extended the debt-forgiveness legislation until the end of this year.

Now, the Richmond eminent-domain seizures probably aren't going to get done before Dec. 31. The whole thing is in litigation and very possibly headed for the Supreme Court. And yet the forgiveness break likely will be extended, said John Vlahoplus, founder and chief strategy officer of Mortgage Resolution Partners. The real-estate industry wants it, he says, and so does the Obama administration, which has fallen short of its goals in getting lenders to modify mortgages.

But will it be extended for two, three or four years, or however long it takes for the lawsuit to churn its way through the courts? Hard to say, and by that time Richmond's home prices -- which Zillow.com says rose29 percent in the past year -- may have increased enough that the town's homeowners have positive equity in their properties. That would go a long way toward resolving the problem that the use of eminent domain was supposed to fix.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
James Greiff at jgreiff@bloomberg.net