Was This Also a Cause of the Housing Collapse

We have heard a great deal about what caused the collapse of housing and the exploding US Debt. There have been many reasons for it but perhaps there is one which may truly have been at its heart, a tax policy.

In 2007 Congress passed and the President signed a change to the Tax Code, called The Mortgage Forgiveness Debt Relief Act and Debt Cancellation. Before this if you lost your house in a bad deal and the bank wrote off he mortgage you were on the hook for taxes on the loss. Short sales had the same effect. Namely the individual had an incentive to not take a lass, there was a dire penalty at the end.

As the IRS says:

  If you owe a debt to someone else and they cancel or forgive that debt, the canceled amount may be taxable.

The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.

This provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion does not apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition. ...

If you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes, depending on the circumstances. When you borrowed the money you were not required to include the loan proceeds in income because you had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount you received as loan proceeds is normally reportable as income because you no longer have an obligation to repay the lender. 

Namely you had strong disincentives prior to this but now you can just walk away with no penalty. That meant that the downside risk was zero. That meant that many people just walked, took no responsibility and let the house drag down everything

There is talk that this may be revised and renewed.  I believe that such a down side risk would actually stabilize the market.