There’s a reason why you probably haven’t heard about the Protecting Americans from Tax Hikes (PATH) Act — its effect on California real estate is almost trivial. While the PATH Act is mostly a giveaway to stock brokers, foreign investors and underwater homeowners who might benefit from changes to tax policy, savvy real estate brokers and agents with an ear to the ground may be able to exploit the law’s milder provisions.

For a small number of real estate owners and investors, the PATH Act provides marginal tax benefits in 2016, including:

  • extended relief for underwater homeowners with recourse mortgages from discharge-of- indebtedness income taxes on short sales; and
  • investment incentives for foreign investors in real estate investment trusts (REITs).

Discharge-of-indebtedness income on short sales

The amount of debt forgiven on the short sale of a principal residence is generally taxable as discharge-of-indebtedness income — also called phantom income since the seller receives no net benefit — unless the mortgage is a nonrecourse debt. Debt forgiven on a nonrecourse debt is not taxable as discharge-of-indebtedness income. [Code of Federal Regulations §1.1001-2(a)(2)]

Under the PATH Act, phantom income realized on recourse mortgages through the 2016 tax year is now excluded from a homeowner’s federal taxable income. Debt discharged after 2016 will also be excluded from income if the short sale purchase agreement was entered into in 2016.

Mortgage holders advocate for the punishment of delinquent homeowners who rely on the short sale remedy. The lending industry pushes struggling homeowners through a variety of hoops to rectify their inability to pay their mortgage. This is a moral consequence that is deeply ingrained in the world of lending. With the exclusion of phantom income from a homeowner’s tax bill, there is one less obstacle for getting rid of a negative equity home.

However, the PATH Act only provides federal tax relief to short sellers with discharge-of-indebtedness income on recourse mortgages. The California Franchise Tax Board (FTB)’s favorable tax treatment of forgiven recourse mortgage debt expired on January 1, 2014. [Calif. Revenue and Taxation Code §17144.5]

California’s laws will conform to federal guidelines when Senate Bill 907 works its way through the state legislature.

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Investment by foreigners incentivized

Whereas the poem at the base of the Statue of Liberty proclaims, “give me your tired, your poor, your huddled masses yearning to breathe free,” the foreign investor provision of the PATH Act can be best summarized with the words “give me your wealthy, your skilled, your eager to spend.”

Foreign investors may now own up to 10% of a publicly traded real estate investment trust (REIT) without the REIT being adversely taxed. Previously, REITs were penalized when selling shares to foreign owners exceeding 5% of the value of the REIT.

Making REIT ownership more widely available to foreign money allows overseas funds to flow into REITs instead of direct ownership of real estate, stocks, bonds or deposits with the Federal Reserve (the Fed). More funds will then be available for REITs to pay even more for what has become a rather fixed supply of improved real estate – unless they take to building new projects.

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REIT investment: playing the real estate game from the sidelines

This provision of the PATH Act is a kickback to REIT managers and stock brokers. The federal government is stoking the fire of artificial demand with no regard for the health of the economy when the sources of these “hot money” funds disappear (as they always do and inevitably will).

PATH Act footprints?

Despite the hoopla attendant with all politically induced schemes, these provisions will have only a moderate and temporary effect on sales volume, pricing and tax consequences for participants in California real estate transactions. Further, government subsidies for recession recoveries do end. To the extent real estate licensees depend on the transactions generated by these programs, they need to have an exit plan into other types of sustainable transactions before the subsidies run their course.

While government incentives temporarily increase sales volume, they do nothing to stimulate organic end user demand. Further, mortgage rates will rise, probably by late 2016. Thus, expect any sales volume boost from these incentives to fall off with prices following within 12 months.

Real estate agents and brokers know inert and static pricing means the death to sales volume, and thus fees. Those able to understand and exploit the volatility in demand created by tax policy will be able to ride the wave before benefits expire and foreign money dries up, and conditions crash back to a normal pace.