The year is 2004. You have just bought your first home. It was a stretch, but the nice mortgage company was able to match you with a financing package that allowed you to borrow the full $400,000 value of your modest Southern California home. If it hadn't been for that interest only ARM you would never have been able to afford the payment, but you made it. You are worried a little, but real estate prices are soaring and you know your income is going to go up.
It is three years later. The real estate bubble has burst. Your home is now worth $350,000. Your ARM has just reset and your payments have exceeded your ability to pay. Your income has been stagnant for the last couple of years. Although you are working a second job, you and your wife have a new child. Your wife is no longer able to work two jobs. Because you are upside down in your house there is no way to refinance. You try as hard as you can, but there is just no way to save your house. It is lost at a foreclosure sale.
Jump forward another six months. You open your mailbox. Inside you find a 1099 from your old mortgage company. It says they are telling the IRS that the difference between what your house brought at the foreclosure sale and the amount of your loan is $50,000. The 1099 lists that $50,000 as additional income. Slowly it dawns that you are supposed to pay tax on that $50,000.
Impossible! Can't happen!! Corpus Juris is smoking dope!!!
No, the above scenario is not impossible. It is becoming quite common. So common that the $50,000 has a name. It is called "Phantom Income." Remember that term. Phantom Income is the final kick in the nuts people who have been foreclosed might expect from their mortgage company. It's all perfectly legal.
Bob Hunt of RealtyTimes has outlined several similar situations. All with similarly bad results. He also explains why the law exists--the government is trying to prevent fraud.
Fortunately, on April 17, 2007, a bipartisan bill H.R.1876 was introduced to deal with the Phantom Income problem. The bill's sponsor Robert Andrews (D-NJ) is working hard with both Republicans and Democrats to change the Internal Revenue Code. Even the Administration has joined with the sponsors. Robert's recently wrote in the Hill's Congress Blog
I am pleased that the President recognized this legislation and I look forward to working with the Administration and my colleagues in the Congress to get this enacted. The recent decline in the nation’s housing market has had a devastating effect on homeowners. Many have had to sell their homes for less than they paid for them, and many times these people have leftover mortgage debt owed to their bank. Banks will sometimes forgive this debt because the homeowner has undergone enough hardship. When this happens, however, the homeowner must pay income tax on this forgiven debt! It is patently unfair to tax people on this “phantom” income, particularly when they have just suffered serious economic loss. That is why I have introduced the Mortgage Cancellation Relief Act (HR 1876), which will relieve this unfair tax burden.I will try to keep you informed as the bill progresses through Congress. You need to know that there is a similar Phantom Income problem when debtors settle with credit card creditors for less than full value. Because the amounts involved are generally smaller, the problem isn't nearly as devastating.
None of us want to learn that our families will be forced to pay taxes when they have no money and have incurred a substantial loss on what, for most, is the most significant asset they own. We do not want to learn that the IRS has the power to make them homeless because they have neither equity nor cash. My legislation will prevent a fundamental unfairness in the lives of those who find themselves in these truly unfortunate circumstances.
