Watch out: Home real estate is back in the sights of Capitol Hill tax reformers.

The staff of the nonpartisan Joint Committee on Taxation has proposed new options for closing the "tax gap," the difference between federal taxes that should be paid under current tax rules and the amounts collected by the Internal Revenue Service. Recommendations from the committee staff carry substantial weight with members of the Senate and House, and frequently get included in tax legislation.

High on the list of methods to collect more of what is owed is to tighten up on homeowners’ billowing write-offs of local and state property taxes, which cost the government about $20 billion a year in revenues.

Under the federal tax code, local real estate taxes on homes generally are deductible. But they are not deductible if the tax payments cover commonplace special assessments designed to pay for improvements that directly benefit taxpayers’ real estate. Examples include local "user fees" for water mains, sewer lines, sidewalks, trees and trash collections.

The problem, according to the tax committee staff, is that current federal law does not require local governments to tell the IRS about property owners’ mixes of regular taxes and nondeductible special-benefit levies. Local governments often provide annual property tax statements to residents with breakouts of assessments. But many homeowners simply deduct the bottom-line taxes paid.

As a result, according to the committee, homeowners get to write off hundreds of millions of dollars a year for tax payments that are not legally deductible. In a 1993 study, the Government Accountability Office estimated that $400 million of that year’s $11 billion in property tax write-offs claimed by homeowners were improper. With deductions this year running nearly double that amount, wrongly claimed write-offs could be in the $700 million range or more.

The committee proposes two possible solutions: Require local governments to provide copies of homeowner tax statements to the IRS with breakouts distinguishing between regular and special-benefit assessments; or require mortgage lenders and loan servicers to report details of homeowners’ property tax escrows with similar breakouts.

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This is a topic that seems to come up fairly often and I think is worth exploring: Does the rise of Mortgage-Backed Securities (MBS) and Collateralized Mortgage Obligations (CMOs) represent a true “paradigm shift” in how risk is decoupled from mortgage originators/lenders and transferred to individual investors and taxpayers? Is this a temporary trend soon to follow unprofitable Dot.coms into the dustbin of history, or a true revolution in risk transference?

MBS/CMO goal: Privatize profits, socialize risk

We have often derided those in the REIC over the past year or so who have claimed that the unprecedented run-up in housing prices over the last 6 years was a “new paradigm”, i.e., a permanent, historic shift in severing the traditional relationships between incomes, rents and RE prices. But what if there’s a kernel of truth to this?

We must remember that MBS/CMOs are what have made issuing NAAVLPs and I/Os profitable, even with tiny risk premiums, because of that oh-so-critical risk-transference. Even the most toxic option-ARM is profitable to the originating lender –in fact, the fees & points (profits) are far higher on toxic loans than they are on traditional 15/30-year FRMs or amortizing ARMs. If you’re a lender, why wouldn’t you want to take boat-loads of risk-free (for you) money? You’d have to be crazy not to, right? Of course, there’s always the possibility of repurchase agreements or class-action lawsuits if things get really bad, but, hey that’s for some other guy to worry about. You’re in it for the short-term profits and couldn’t care less about the long view, right?

The new MBS/CMO risk transfer model has been working SO well for lenders that I fear only a complete economic meltdown (resulting from it) would deter banks from voluntarily continuing its use in the future. And, as Randy has pointed out, the current anti-regulation/pro-banking bias in government is so strong, involuntary regulations (with real enforcement) are pretty much out of the question –for now.

I believe our best hope where toxic loans are concerned is for MBS investors to begin to recognize that the underlying risk has been severely under-priced and demand greater premiums and/or risk disclosure. This should result in higher mortgage interest rates and the return of “quaint” things like full-documentation, which in turn would deter widespread use of these loans. Of course, this would require FB defaults on a massive scale, something we could expect to see beginning next year, and continuing in waves for several more years.

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