Feb 6 (The following statement was released by the rating agency)
The recently expired tax relief provided by the Mortgage Forgiveness Debt Relief Act (MFDRA) of 2007 may lead to modestly negative pressure on liquidation timelines and recoveries for legacy U.S. mortgage investors if it is not renewed, according to Fitch Ratings.
The tax relief expired Jan. 1, 2014, creating larger tax burdens for underwater borrowers who receive some form of mortgage debt forgiveness. If the tax breaks are not renewed, Fitch expects declines in short sale volume, fewer principal forgiveness modifications, and higher re-default rates on those that are granted.
Mortgage debt that is cancelled or forgiven by the lender - through a foreclosure, short sale or loan modification - is typically considered income for tax purposes. The MFDRA provided tax relief by allowing certain borrowers to exclude such income on their tax returns. The act applied only to debt associated with a primary residence, and no more than $2 million of debt could be excluded per year.
The MFDRA was originally signed into law in December 2007 and Congress is currently considering several bills that would extend the tax relief through 2015 or 2016. The extension has broad support from state attorneys general, and most housing and consumer advocacy groups. However, the passage of an extension bill by Congress is not a given, and at present the tax breaks remain expired.
Fitch expects a decline in the volume of short sales and principal forgiveness modifications as a result of the MFDRA's expiration. Without the tax exemption on the forgiven debt amount, there is less incentive for distressed borrowers to agree to a voluntary property sale that will not pay the loan off in full. This in turn will likely increase the number of involuntary foreclosure sales. The MFDRA's expiration also provides servicers less incentive to offer principal forgiveness modifications since the tax burden on the borrower increases the likelihood of re-default. Servicers may increasingly opt instead for principal forbearance, which requires the borrower to repay the reduced principal amount at the end of the loan term.
If Congress does not extend the MFDRA, the rating implications are likely to be modestly negative for legacy U.S. RMBS. In 2013, voluntary short sales accounted for roughly half of all distressed property sales within U.S. RMBS and short sales experienced faster resolutions and higher recoveries than involuntary sales. A reduction in short sale activity will likely increase negative pressure on both timelines and recoveries, offsetting some of the benefits of the recent gains in home prices.