Rectifying the Tax Treatment of Shared Appreciation Mortgages

Abstract:     
The current mortgage crisis has increased interest in innovative shared appreciation mortgages (SAMs). The lender accepts a lower fixed interest rate under a SAM in return for a share of the appreciation - or value - of the home over time. SAMs have attracted much recent interest due to their improved (i) spreading of the loss risk across the financial system (thereby reducing the chance of a borrower default when home prices fall), and (ii) correlation of payment timing with the typical lifetime earnings cycle (i.e., lower mortgage payments earlier in one's career).

Unfortunately, the current tax rules make it essentially impossible to develop SAM markets in the U.S. The tax rules for debt instruments with contingent interest generally require both the borrower and lender to report contingent interest each year as if the instrument bore a market rate of (higher) fixed interest. These rules are tax neutral for most instruments, since both the borrower and lender account for the additional contingent interest at the same time. These contingent debt tax rules are not neutral, however, in the case of SAMs since a special earlier-enacted, and unrelated, provision defers the homeowner's interest deductions until payment. The interaction of the two sets of unrelated rules provides an asymmetric result of annual lender inclusions with deferred homeowner deductions. This adverse timing asymmetry can impose a significant net tax cost that makes SAMs extremely unattractive. Curiously, SAMs issued in connection with a workout - rather than upon original home purchase - are not subject to this timing asymmetry since the workout lender does not have to accrue the contingent interest each year. The uniquely punitive treatment for original-issuance SAMs therefore seems quite accidental, especially given the lack of any coherent justification for such singling out. And beyond the negative timing asymmetry and inexplicable line drawing, additional tax concerns arise due to uncertainty in reaching definitive tax results (e.g., threshold uncertainty over whether a SAM should even be treated as debt for tax purposes).

In light of the foregoing, we consider three different reform proposals that could remove the tax impediments to the SAM markets: deferral of the lender's contingent interest inclusions; acceleration of the homeowner's contingent interest deductions (to match the lender's annual inclusions); or treatment of the SAM as equity, rather than debt. While all three of these alternatives would eliminate the current poor treatment of original-issuance SAMs, we strongly believe that the best of the alternatives is the first. As discussed in greater detail in the Article, this approach is relatively easy to implement through very limited regulatory changes, can be structured to have little or no consequences

Keywords: shared appreciation mortgage, sam, contingent interest, mortgage crisis, debt

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