Cancellation of debt a growing issue - need for informed tax preparers and changed tax rules

In preparing for an upcoming presentation that basically looks at beyond the current filing season for CPAs, I delved into some data on growing debt problems consumers face. It would appear that more return preparers will be seeing clients with cancellation of debt (COD) forms 1099-A and 1099-C. So more will need to know what COD income is and when it might be excluded under IRC section 108 or when it might just be a property transactions (which is often the case when non-recourse debt is involved). The increase in number of taxpayers with COD income issues may also cause Congress to have to simplify the law, such as by following recommendations made by the National Taxpayer Advocate in 2008. In that year, the report identified COD issues as "the 'poster child' for complexity (report, pages vi and 39-53). (Also see my 2/14/12 post.)

Here is some of the data I found:

Mortgage Bankers Association

• -“1 out of every 200 homes will be foreclosed upon. For a city like Washington, D.C., that translates to 3,000 Washingtonians losing their homes to foreclosure each year. Every three months, 250,000 new families enter into foreclosure.”     (reference)
• •“By several measures, mortgage delinquencies are about half way back to long-term, pre-recession levels.  The total delinquency rate peaked at 10.1 percent in the first quarter of 2010.  It now stands at 7.6 percent, about half way to the longer-term pre-recession average of roughly 5 percent.” (2/16/12 press release)

Corelogic

• •“According to Corelogic’s Negative Equity report, the mortgages on more than 11.1 million homes, or 22.8 percent of the nation’s 48.7 million mortgaged homes, are underwater.” (reference)

Student Loan Data  

• Per the Project on Student Debt, 2/3 college students who graduated in 2010 had debt averaging $25,250, 5% higher than for 2009 
• Per the Department of Education, FY 2009 national student loan cohort default rate was 8.8% (7% for FY2008) 
• Student loan debt exceeds $1 trillion, which is greater than total credit card debt. See "Student-Loan Debt Tops $1 Trillion," by Mitchell and Jackson-Randall, Wall Street Journal, 3/22/12, A5 and information from the Consumer Finance Protection Bureau

IRS

• The IRS projects an increase in the number of 1099-A and 1099-C forms filed (Pub 6961). 

 

Joint Economic Committee

• In December 2011, the JEC released a report that describes various financial information for each state including issues in the mortgage market. For example, for Nevada (page 59), it reports: "As of the 3rd quarter of 2011, 7.9 percent of all mortgages, including 18.8 percent of subprime mortgages, were in foreclosure in Nevada."

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My Recommendations

1. Should any tax rules be modified to address these issues? I think so. One of the possible ways to exclude COD income is if the borrower is insolvent. To measure insolvency, you see if your debts (usually easy to measure) exceed the fair market value of all of your assets (hard to both identify and value). If the person is insolvent, they can exclude the COD income to the extent of insolvency. They must also reduce the basis of their assets by that excluded income. Since the assets are likely things like cars and clothing that are likely to be disposed of at a loss someday, even with the reduced basis, with the loss being non-deductible, the effort to measure insolvency is a wasted one.  I agree with the National Taxpayer Advocate who suggested that there be a dollar amount specified for just being able to exclude COD income (2008 report, pages 391-396). I think the dollar limit should be no higher than $30,000.  Of course, that may seem to fly in the face of the current up to $2 million relief possible for a home mortgage interest (which expires at the end of 2012 unless renewed). For more on the overgenerosity of this particular income exclusion, see a recent law review article by Bradford Anderson - "Robbing Peter to Pay for Paul's Residential Real Estate Speculation: The Injustice of Not Taxing Forgiven Mortgage Debt," Seton Hall Legislative Journal, Vol 36, Issue 1 (2011).
2. The deduction for interest on a home equity loan should be phased out because it encourage people to put debt on their home. While home prices are down and many people do not even have equity in their home, is the time to enact this change.
3. Financial literacy needs to be part of K-12 instruction too to help individuals understand how to keep themselves out of debt and how to save.

What do you think?

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