Will this do more harm than good?

The Wall Street Journal reports($) that the Congressional initiative to reduce the "debt forgiveness" tax consequences on foreclosed homes is likely to result in higher taxes on the sale of second homes.

The Ways and Means Committee, the House's tax-writing panel, approved a bill yesterday under which homeowners facing foreclosure won't get stuck with a tax bill if part of their debt is forgiven by lenders. Currently, forgiven debt is treated as income to the borrower and is subject to tax.

The committee decided to pay for the tax break, as required by congressional budget rules, by restricting homeowners' ability to avoid or reduce the taxes on the sale of second homes.
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Under current law, a person can exclude from taxes up to $250,000 in capital gains on the sale of a principal residence. Up to $500,000 of gains can be excluded for married couples. A second home can become a principal residence as long as the taxpayer has lived there for two of the previous five years.The bill approved yesterday would change those rules. Under it, the size of the tax break for a second home would be tied to the portion of time, out of all the years a house is owned, that it serves as a principal residence. Living in a property longer would result in a larger tax break on any gains when it is sold.

There are two interesting issues here.

First, unless tax laws have changed recently, the debt forgiveness tax only applies to the extent that it would make the taxpayer insolvent (e.g., if you have a net worth of $10,000 and your debt forgiveness is $20,000, you owe taxes on only $10,000).

Since many of the foreclosed homes today are owned by individuals of modest means (and probably zero or negative net worth after all their assets and liabilities are tabulated), there doesn't seem to be a big benefit here. Once again, this tax law change is likely to aid the wealthy more than the first-time, subprime, former homeowner.

Second, the increase in taxes for second homes is likely to make these properties less desirable for both existing and potential owners. Should this law go into effect, current owners of second homes will, at some point, be able to do the calculation of what their taxes will be upon selling their second home and may decide to get out while the tax burden is less.

With existing home sales tanking and, earlier today, new home sales searching for a new, much lower bottom as reported by Econoday, this bill may do more harm than good.

More harm than good, that is, unless you are wealthy and you are looking to get out from under your real estate bet that has clearly gone bad with a smaller tax liability.