Mortgage Debt Relief Forgiveness Act of 2007

Earlier this week the House of Representatives passed the Mortgage Debt Relief Forgiveness Act of 2007. The President is not expected to veto.

There are several tax reductions included in this bill. Two of these reductions are:

• A three year exclusion (ending 12/31/09) for mortgage debt forgiveness income on a principal residence, up to $2 million.

• Extension of the $500,000 exclusion on sales on principal residences to people whose spouses die within two years of the sale, if the spouses would have been qualified for the $500,000 exclusion at the time of the death.

I am always in favor of tax reductions, but as my previous post indicated sometimes tax reductions don’t have the effect the general public believes they do.

The first reduction is interesting. If a lender forgives a borrower of his debt, the amount that has been forgiven is treated as income which is taxable and reported on Form 1099-C. However, if a person is deemed to be insolvent no income from cancellation of debt is taxable. In the current market it has become increasingly common to see homes foreclosed or sold ‘short’ (i.e. sold for less than the debt owed). In those instances lenders become unsecured creditors and can either attempt to collect the money through other means or ‘forgive’ the debt. If a lender is willing to forgive the debt, it is usually an indication that the lender feels they will not collect any additional money because the borrower is probably insolvent. So this portion of the bill probably has no effect on tax revenues because only in exceptions is forgiven debt related to a principal residence taxable in the first place.

The second tax reduction really pulls at your heartstrings. Nobody wants to see widowed spouses pay extra taxes. Under current law, homeowners who file married jointly can exclude up to $500,000 of gain on the sale of principal residences ($250,000 for single taxpayers). Gain is calculated as the difference between sales price and basis (roughly original cost plus improvements made). I mentioned earlier that the median home value for the 3rd quarter 2007 was $220,000 which means half of all homeowners won’t have a $250,000 gain even if their home was given to them at no cost. So how many people does this provision affect? If we assume an appreciation rate of 3 times cost, only those in homes worth $375,000 would be affected (assuming basis of $125,000). But in order to have a gain of $250K on a $375K home one would probably have to own that home since before 1980 (based on national appreciation averages). The National Association of Realtors doesn’t make some of this data available to non-members, but suffice it to say that in order to benefit you would have to have an extremely valuable home (probably $1M+) and a low basis (probably bought in the 1970’s). Also remember that this provision only applies to principal residences not farmland or undeveloped land were oftentimes the real appreciation is seen.

So once again we see a tax reduction from Congress which I certainly favor. However, you can probably count on a couple of hands the number of people that will actually benefit.

Mortgage Interest Deduction – Driving the Economy or Taking it for a Ride?

Anytime tax policy is targeted toward a specific segment of society such as homeowners, parents, investors, students or savers, there is bound to be discussion of the fairness of the tax policy. Who benefits? Who is penalized?

The mortgage interest deduction is no different. According to the National Association of Realtors, everyone benefits from this deduction. Its claim is that when tax benefits are removed from real estate ownership that the value declines. This sounds plausible, but by how much? NAR calculations indicate a 15% decline which translates into $20,000 to $30,000 reduction in equity to the typical homeowner. That sounds awfully high to me.

For 3rd quarter 2007 median single-family home price was around $220,000. If we assume a taxpayer financed a 100% to purchase a median home with a 30-year fixed mortgage at 7%, the monthly mortgage payment would be $1,464.

Let’s look at our example for a 30 year period. In the 360 months, total payments would be $526,921 of which $306,920 would be interest. For taxpayers in the 25% tax bracket this leads to tax savings of $76,730. So if the homeowner is effectively only paying $450,191 (526,921 less 76,730) over the life of the loan, how much home could be purchased if there was no deduction and $1,250 (450,191 divided by 360) is all that can be spent per month? At the same interest rate (7%) the home value would be $188,000. That’s a $32K difference which is very significant.

Remember though that the mortgage deduction doesn’t occur in a vacuum. Taxpayers can either take a standard deduction or itemize their deductions. If we only look at the ‘effective’ tax benefit (the amount that surpasses what would have been allowed using standard deductions), we see that only $53,079 of the interest provides a tax benefit. So at 25% that yields $13,270 in tax savings. Now the taxpayer is paying $513,651 (526,921 less 13,270) over the life of the loan. If $1,427 is now available on a monthly basis under the same assumptions, a $215,000 home could be purchased. That’s only a $5,000 (about 2.27%) difference in purchasing power which is a far cry from the 15% the realtors claim.

Am I advocating elimination of the mortgage interest deduction? Not necessarily. It is an idea which deserves some research and input from the real estate, mortgage and tax preparation industries as well as from consumer groups. But spending over $306,000 to save $13,270 in taxes makes this guy look like a genius.

Worst State Department of Revenue Websites

Actually, this isn't as much a list of bad department of revenue websites as it is a rant about the Alabama Department of Revenue. Oftentimes, I have to do research about state tax laws for surrounding states and Alabama is one of the worst.

The website makes it difficult to find information and many of the rules make it costly to comply. For instance, Alabama is a state that still has local (city/county) governments collect and assess their own sales tax. Unlike many states that have a uniform tax form for all counties and cities, Alabama has jurisdictions that have a separate form.

Separate local government forms make it costly for small business subject to sales tax collection to comply. The business must first be aware that the additional form is required. Then, it must know how to report the calculations. Finally, it must know when and where to submit both the form and the sales tax collected.

Obviously, the additional filing requirements are more expensive to meet than a state with a consolidated form whether the business performs this function with staff in house or outsources to a CPA. Soon I hope to calculate a 'break-even' point for conducting business in a new state. This will include the cost to register and become 'legal' in that state as well as the costs to comply with continuing reporting requirements. I theorize that for small businesses many states' requirements are so burdensome as to even be cost effective to enter the state. I would now like to quantify that.

Fair Tax...Unfair Logic

Generally speaking, I am leaning towards support for the 'FairTax'. What I don't agree with is some of the claims being made by FairTax supporters.

From FairTax.org is this statement: 'They may not know it, but they are paying corporate income taxes, employer payroll taxes, plus the associated compliance costs that are hidden in the price of every retail purchase they make.' This statement is in regards to the concern that retirees that currently have no taxable income will now be taxed on money they have saved and are now spending, essentially being 'double taxed'.

The issue I have with the statement is that it treats retail prices as if they are determined based on a recovery of costs. This is not true. Consumer behavior (demand) is a major force in pricing.

Consider two identical products from different manufacturers that sell for $100. Both companies incur the same cost and have identical profit margins on the products. Company A has net income of $1M and pays $400K in federal, state and local income taxes (40% rate assumed). Company B however does not have any net profit either because of other product lines, losses that have carried forward, or higher indirect overhead costs.

Does this mean that Company B is overcharging and should lower its price? Is Company A undercharging. Should A increas its selling price?

Simply put, if consumers see two identical products with the same quality, function and features, they will not care what each company's costs were. The notion that costs (and taxes) or savings (tax reductions) are passed on to the consumer is not generally true.

Comparative Advantage

I’ve always been a proponent of partnering with other businesses as a means to enhance my own business. Some of these businesses I align myself with would even be considered competitors by most. So I must be a sucker right? Well…maybe.

The reason I have been so willing to work with others is because of the Principle of Comparative Advantage. I’m don’t refer or ‘outsource’ highly profitable services to other providers. Contrarily, I recommend the use of others for what is labor intensive and oftentimes not very profitable for a small CPA firm working on a small scale.

In turn for my referring clients and prospects to them, they refer clients and prospects to me. They are referring small businesses that need more profitable tax, accounting and consulting services than what I am forgoing. This only seems to make sense to me, but many CPA firms are unwilling to engage in this practice.

One of the criticisms I hear is that the other providers can’t provide the service as well as the CPA firm. This point is actually debatable, but for now let’s concede this point agreeing that CPA firms are more qualified to provide the service than a larger national company. This is the beauty of the Principle of Comparative Advantage.

In this scenario I have an absolute advantage over the other provider in the service being rendered. I could do it better than the other person(s). But since I have an even larger advantage over that person in the areas of tax preparation and planning, that is where I should focus my time. In the process both of us become more profitable, hence the reason they are so willing to refer good business to me.

And that is why I continue to refer people to other third-party providers even while most CPAs attempt to hoard the clientele, but shhhh!....don’t tell them about my secret this comparative advantage is what leads to my competitive advantage.

Unwanted Publicity

Many say even bad publicity is good publicity. I think I have found an exception.

In the previous post I wrote about the websites of many CPA firms. Often you see these firms attempt to link themselves to other sites to direct traffic and create a 'buzz'. The Georgia Department of Revenue's website has a link about a former payroll provider in the state. From the 'Withholding Taxes' tab under business taxes you have a link labeled 'Information for Businesses Using 20/20 Payroll Solutions, Inc.'

Talk about your bad publicity! It provides information about the alleged theft of company payroll taxes withheld, the need to contact the Cobb County Investigator and most importantly businesses who have been victimized are still ultimately responsible for paying the state withholding tax liability.

That's right. Companies are always responsible for paying the government regardless of whether one of your own employees or an outsourced third party stole from you. That's something to think about when hiring accounting personnel or engaging in accounting, tax or payroll services. Company ownership and management can never shirk its responsibility to make sure things are done right.

Tax Advice From a Can

For some time I have been thinking about how to create a presence for myself and my practice on the web. I receive all sorts of junk mail from vendors trying to get me to use their website template. It certainly seems tempting. Just pay someone else a fixed fee and 'Poof!' your on the web. While these website peddlers promise to give you a presence to differentiate yourself from the rest of your peers, the exact opposite happens.

The CPA firms end up with a product that is identical to every other CPA firm. A recent Yahoo! search yielded the following information:

121 CPA firms are currently running the exact same article about how to secure a commercial loan. Not only is the article not creative in the sense that the firms are left with word-for-word what everyone else has, but also the article is not very timely. The last thing small businesses need to be told in this market is to put together a 'smoke and mirrors' method of convincing a lender of your credit worthiness. That's essentially what all the 120+ firms are advising under the sub-heading 'Realize the Value of Schmooze'!

Even in Cartersville, GA there are two members of the local Chamber of Commerce who are running this article as well as other identical articles in the same newsletter. You go to the first firms site and the welcome page tells you, "Our high standards, responsive service and specialized staff spell the difference between our firm and the rest."

You then go to the second firm's website and they proclaim, "Our high standards, responsive service and specialized staff spell the difference between our firm and the rest."

I guess the definition of specialized staff includes: Opening your checkbook and purchasing a 'canned' website chock-ful of information of which you're unqualified to develop yourself.

If this is what differentiation is all about, no thanks! I prefer not to receive 'cookie-cutter' advise in the financial services arena and I don't want to be one dispensing it.