The Mortgage Forgiveness Debt Relief Act of 2007 expires at the end of this year. And that sets up the housing industry for what will probably be a very interesting market in the spring. And by interesting, I mean very bad for banks and builders.
The law allows the owners of principal residences who sell their homes for less than what is owed to request forgiveness from the Internal Revenue Service for taxes owed on the imputed income.
I will explain. If your principal mortgage balance is $300,000 but your lender agrees to allow you to sell your home and pay it less than what is owed, say $200,000, the forgiven $100,000 is taxable income, according to the IRS.
The Mortgage Forgiveness Debt Relief Act of 2007 allows the IRS to forgive the taxes owed on the forgiven amount as long as the sale is completed that year. Originally signed into law by President George W. Bush with an expiration date of year-end 2009, the act was extended to year-end 2012 by the Emergency Economic Stabilization Act of 2008.
The most common question I am receiving from real estate professionals today is, will it be extended again? I do not know.
What I do know, however, is that homeowners do not have the time to wait for an answer. A short sale typically takes several months to be approved by a mortgage lender; and that is after the seller has a ratified contract from a buyer in place. Finding a buyer can take several months.
Exacerbating the potential issues for the housing market for this spring and the rest of this year is that homeowners have been getting squeezed in a vise and are now just realizing it.
For the past several years, many people have postponed selling the properties they are upside-down on, in the hope that a mortgage loan modification program would afford them the opportunity to not have to sell.
That hope has now hit the very real, serious, immediate and practical reality of the risks of attempting to maintain a residence they are upside-down on and can't truly afford without a loan modification.
Throughout the U.S., real estate agents are getting in touch with their clients and making them aware of this sober reality: Time's up, the safety net is being removed, the loan mod isn't coming through. What are you going to do? You have to decide right now.
This isn't just crying fire in a crowded theater. It's crying fire in a crowded theater that is actually on fire.
This may be the catalyst that provides for what I call the "simultaneous collective epiphany," the point at which everyone everywhere experiences the same recognition of reality at the same time.
The logical result of such action is that home listings of for-sale properties will spike this spring, and we will see a race by sellers to discount asking prices in order to attract buyers and close on a sale before the end of the year.
In that environment, it will be practically impossible for homebuilders to compete on price. The homebuilders' stocks are not reflecting the potential impact of this scenario. I have recently advised selling long positions in the builders, and I reiterate that opinion here. That doesn't mean go short; it just means you should avoid the sector, at least until this immediate issue is resolved.
It is possible that Congress will vote to extend the forgiveness provision again, but since this is an election year, counting on an extension is unwise.
As this process unfolds, the mortgage money-centers, JPMorgan (JPM), Bank of America (BAC) and Wells Fargo (WFC), will also be profoundly affected. Their operations are not set up to handle a high volume of short-sale requests quickly. They are also not prepared for the probable substantially larger losses they will have to accept on their existing mortgages as competition to discount asking prices on homes increases.
As such, avoiding them is prudent as well.
