Federal Bail Out and Foreclosure Alternatives

So, surprise, surprise - I am in favor of a very specific form of government assistance to the increasing number of mortgage holders who simply cannot pay their mortgage: not piling on. As I understand it (and that may be somewhat inacurately), most loan forgiveness becomes a taxable event. Let's take a hypothetical example from the high-middle estimates of the extent to which 2005-6 housing prices represented a bubble. Borrower cannot make payments on a $450,000 mortgage and the house that (with lender agreement) is short-sold for $300,000. Borrower then owes taxes on $150,000, unless completely insolvent - tens of thousands of dollars. I would guess this is also the case if the lender decided to forgive a percentage of the loan (say, $100,000) in order to reach a level at which the borrower actually had an acceptably high chance of making the payments.

So, if Senator Dodd and Clinton et al. want to help, they ought to start by getting rid of this provision in the tax code as applied to a single primary residence - in all fairness, the borrower hasn't "made" any money in this deal. And the loss to the Treasury is hypothetical, like the borrower's ability to pay.

But I recommend a concommitant change: a return to something close to the status quo ante for the treatment of capital gains on the sale of ALL primary residences, not just the ones that
benefit from this tax forgiveness. Capital gains would remain tax free so long as all gains go back into a primary residence (and there could be flexibility about this meaning equity or total cost), with the possibility of the return of the one-time exemption to allow for one trade-down to assist labor mobility and those downsizing or leaving the home-owning ranks entirely.

Of course I'd also like to see the end to the mortgage interest exemption in the name of general simplification and fairness, but that's not integral to the above trade-off.

While I'm thinking about it: if the above high-but-not=off-the-charts-looney scenario were actually relevant (33% drop in value, assume nonrecourse loan, assume inability to pay), then the lender and the borrower could have a prima facia common interest in leaving the "homeowner" in place, even at the cost of a radical write-off of the loan becuase of the transaction costs and the possibility that the borrower could actually afford fixed payments and the new, lower value - or even something a bit above the value, to reflect their own interest in remaining in their home. It could also reset the appraisal (lowering the property tax assessment) and allow for a more orderly progression to lower housing prices 9and therefore costs). Bummer about all the lost equity for all (us) other owners, but those are the breaks - it would happen anyway, and potentially in a more ugly fashion.

Of course this would also lead other borrowers to want the same thing, and to be willing to play brinksmanship with their mortagge holder to get it, but that's between those two parties. Don't see there's a role her for the kind offices of Dodd and his friends.