Couple B purchased a home for an original appropriately proportionate mortgage of about $150,000. As the market value of their home increased over the years they have constantly refinanced to take out additional cash equal to the jump in value, using some of the money to pay off credit card debt, which, once paid off, they promptly begin to build up all over again. The mortgage, and home value, had grown to in excess of $300,000. They obviously lived above their means.
Couple A received their recent 401(k) account statements and discovered that, due to the current financial FU, their investment for retirement has been cut in half. They are “out of pocket” in excess of $100,000 each!
Couple B got to the point that they could not afford to pay their mortgage. The value of their home plummeted, so they could not refinance again to get more cash. It got to the point where they just packed their car and drove away from the property, abandoning it and the mortgage. The home was eventually sold (to one of my clients – so you know this part is a true story) for a little over $100,000 in a foreclosure sale. The bank wrote off $200,000 in mortgage debt as uncollectible, and Couple B were “forgiven” some $200,000 in mortgage debt.
Couple A did everything right. Through no fault of their own, but as a result of the actions of Couple B, and many, many more like them, they have lost over $200,000.
Couple B did everything wrong. Yet they have walked away from $200,000 in debt. They are basically $200,000 “in pocket”
Generally when debt is forgiven the amount of the forgiveness is fully taxable as ordinary income. As Couple B was forgiven $200,000 in mortgage debt they would pretty much have to pay federal income tax on $200,000 (although not quite that simple – there is a calculation). However, George W and his colleagues in Washington in their infinite wisdom have passed a law that exempts the $200,000 in mortgage debt forgiveness for Couple B from federal income tax (actually there were provisions in the Tax Code prior to the Mortgage Forgiveness Debt Relief Act of 2007 under which they could avoid tax on all or part of the debt forgiven – for a good overview of the appropriate tax law check out TAX GIRL Kelly Erb’s post “Foreclosures, Debt Forgiveness and Mortgage Losses Explained”).
Plus the same politicians have also decided to bail out the irresponsible bank(s) who continued to allow Couple B to refinance and repeatedly take out more and more cash.
So the moral of the story – do not conduct your financial life in a responsible and prudent manor. Be irresponsible and reckless. If anything happens you can count on the government to bail you out.
As Yakov Smirnoff would say, “What a country!”.