Debt and Taxes

Can we forgive our way back to prosperity?

Imagine this: you’re underwater on your mortgage and out of a job. You’ve been struggling to make payments on your home, but you’re not sure you can make it. You’re considering a short-sale and other options. Then you get a notice from a group called “Rolling Jubilee” that they have purchased your mortgage and forgiven it. You’d be delirious, right?

Well, maybe. Because that lovely act—debt forgiveness—is a taxable event. That is, forgiving a $200 thousand mortgage creates taxable income of $200 thousand. This group solicits tax-free donations, buys troubled debt at a discount, and forgives the loans. They maintain that they’re not making any money from the debt cancellation, so they don’t need to file any paperwork. But the IRS may have a different take.

Because when a bank takes a loss a loan, they deduct that loss as a business expense. Any subsequent recovery is income. It makes no difference whether that recovery is earned by a hedge fund speculating or by a homeowner who is unexpectedly mortgage-free. Debt forgiveness is income. Otherwise we could have our employers make “loans” to us every paycheck and then “forgive” the loans. Cute, but wrong.

But you’d happily exchange a $200 thousand debt to a bank for a $56 thousand debt to the IRS, right? Again, maybe. The IRS has a lot more collection muscle than Bank of America. And tax obligations typically survive the bankruptcy process.

Which brings up my final point: we already have a perfectly fine debt-forgiveness process. It’s called bankruptcy. It’s legal, orderly, and doesn’t create new tax obligations. Well-meaning but misinformed folks like Rolling Jubilee need to do their homework. Because the Devil—or in this case, the IRS—is in the details.

Douglas R. Tengdin, CFA
Chief Investment Officer
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By | 2014-09-09T10:50:25+00:00 November 15th, 2012|Global Market Update|0 Comments

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