By Nick Timiraos  (Wall Street Journal)

Most analysts expected housing might hit a rough patch after the home-buyer tax credit expired in April.  But is the plunge in demand becoming worse than expected?

It’s a fair question, given Wednesday’s report that new home sales plunged 33%  in May from April and were off 18% from one year ago.

Moreover, the Mortgage Bankers Association reported that mortgage rates fell again, down to 4.75% last week from 4.82% two weeks ago. By comparison, rates were slightly higher one year ago, at around 5.3%.

Yet demand for refinancing or for taking out new loans is tepid. The index that tracks new purchase-loan activity was down 2.3% from last week and nearly 37% from one year ago.

That weakness is also showing up in home sales contracts signed in May, which the National Association of Realtors estimates is down 10% to 15% from one year earlier.  Those deals won’t close until later this summer, which means that we could be in for several more months of gloomy housing indicators.

One big question is how quickly demand will bounce back as the market works through the post-tax credit hangover.  Another big question: How quickly will new supply come onto the market in those intervening months? If more banks put homes on the market this summer and more sellers list their homes, that pushes up inventories and pushes down prices.

Housing economists are gloomier about the prospects than just a month ago, which suggests that there may be more evidence that the tax-credit lull won’t be as temporary as once believed.

The answers to those questions could foretell whether housing prices drop just 5%, or if there’s truly a “double-dip” in store, that would mean drops of around 10-15%.

Thomas insisted that his lender, American Home Mortgage Servicing, agree not to come after him for the estimated $174,000 he still owed on his two mortgages.

The first wave of U.S. mortgage defaults was spurred by lenders who made bad loans and borrowers who wound up with larger monthly payments than they could ever hope to manage. Lately, something altogether different has been making an increasing contribution to soured debt: Americans choosing to stop making mortgage payments they actually can afford.

“Strategic” defaults accounted for at least 12 percent of all defaults in February, up from about 4 percent in mid-2007, according to a recent Morgan Stanley (NYSE:MS – News) report. Analysts led by Vishwanath Tirupattur classified a default as strategic when a homeowner who hadn’t previously been delinquent made an on-time mortgage payment one month; skipped payments for the next three months; and stayed current on other consumer debt of $10,000 or more.

Housing analysts say strategic defaults mainly occur when a home’s value has dropped below the balance remaining on the mortgage. A homeowner in that position may decide that continuing to make payments is throwing money away, or may default to get the lender to modify the loan. An estimated one in five U.S. homes with a mortgage has “negative” home equity, according to Zillow.com.

In March the Obama Administration announced it was coming up with a plan to encourage cuts to the principal on mortgages exceeding the worth of properties. Previous government efforts did not emphasize principal reduction but focused on lowering monthly payments.

Whatever you think of strategic defaults from an ethical point of view, they appear to be aiding the economy, temporarily, at least, by boosting consumer spending and allowing homeowners to stay current on their other bills. Consumer spending, which accounts for about 70 percent of economic activity in the U.S., rose at a 3.6 percent pace last quarter, more than economists forecast. The increase, the biggest since 2007, was somewhat puzzling considering that the underemployment rate was at 16.9 percent in March, near the highest level in at least 16 years. (The rate includes people without jobs, part-time workers who would prefer a full-time position, and people who want work but have given up looking.)

All told, borrowers who aren’t making mortgage payments are probably skipping roughly $100 billion annually, an amount equal to 1 percent of consumer spending, according to Mark Zandi, chief economist at Moody’s Economy.com. Zandi likens the money to “a form of stimulus, a little tax cut.”

Not all of that “tax cut” is being spent on iPads, vacations, and lattes. “Presumably these homeowners know they’re going to have to start paying again” to live somewhere, says Zandi. He suggests that falling delinquencies on credit cards and auto loans may be a sign that homeowners are using mortgage money to pay down other debt.

The bottom line: By not making mortgage payments on “underwater” homes, borrowers may be paradoxically helping to boost the economy.

A Surprise Tax Hit on Foreclosures

For People Who Lose or Walk Away From Their Homes, A Big Tax Bill May Loom

Maxine McDaniel has a message for Americans considering walking away from an unaffordable mortgage: Beware of taxes.

Though not every homeowner who’s underwater on a mortgage need worry, many are finding that a foreclosure or other form of housing loss can lead to a big tax obligation.

Maxine McDaniel walked away from her Loveland, Colo., home in January. Now the 59-year-old nurse faces a potentially huge tax bill.

In Ms. McDaniel’s case, the 59-year-old in January abandoned the 4,300-square-foot Loveland, Colo., home she and her late husband built. After her husband’s death in July 2008, Ms. McDaniel, who earns about $34,000 a year as a home-health nurse, couldn’t maintain the $3,000 monthly payments necessary on her nearly $500,000 interest-only mortgage. So she stopped making them and moved in with an uncle.

Now, she’s bracing for the next blow: an Internal Revenue Service form detailing as much as $150,000 in debt canceled by the bank when it took control of the house. The canceled debt is a form of income, says the IRS—meaning she’ll owe taxes on it.

“I had no clue this would happen,” says Ms. McDaniel, who, with her husband, had refinanced at least three times, including one cash-out loan. That transaction caused her problems because, while canceled debt originally used to buy or build a house can be exempted from tax filings, debt used for other purposes cannot. “I just thought I’d get out from under the house and that would be that,” she says.

As the U.S. economy continues struggling with the fallout of the debt-induced housing crisis, millions of homeowners like Ms. McDaniel are discovering that their decision to walk away from a mortgage could result in tax bills running into the thousands or tens of thousands of dollars.

The upshot: anyone weighing whether or not to seek a mortgage modification—or debating whether to abandon a house that is worth less than the mortgage—should consider the tax treatment carefully before making a move. The same holds for any form of consumer debt that a bank ultimately cancels, including credit-card balances or an auto lease.

Federal and state tax laws have long viewed canceled debt as income because consumers who borrow money to buy a house—or who pull money out of their house to buy cars and such—and then don’t pay it back “wind up ahead of where they were,” says an IRS spokesman.

Thus far this year, Michele Knight, a CPA with a high-end clientele in Keystone, Colo., has had five clients owe taxes tied to houses and another five tied to credit cards and auto leases. “They’re calling me in tears and saying, ‘What do you mean I owe taxes?’” she says. “I never would have expected it.”

Dianne Corsbie, a White Plains, N.Y., financial planner, says about 5% of her 200-client practice owes taxes because of a foreclosure, most tied to investment properties. In Napa, Calif., Duane Carey, owner of a Ranch Tax Service, says every fifth person he sees “comes in angry, holding one of these 1099s.”

Overall, the IRS estimates that individual taxpayers will have filed nearly 3.6 million tax returns for 2009 that include income from canceled debt. That’s down a bit from 2008, but up 17% from 2007. The numbers include taxes due on primary homes, vacation and rental property, credit cards, auto leases and other canceled debts. The IRS projects the numbers to rise in coming years.

Part of that rise will likely come as the government expands its mortgage-modification program, including a call in March by the Obama administration for banks to reduce principal as a way to help people remain in their homes. That reduction could lead to tax obligations.

At first the government’s mortgage-modification program focused on primary mortgages, which are tied to the purchase or construction of a primary residence, and which are eligible for exemption under a 2007 Congressional act aimed at helping homeowners avoid the tax implications of a foreclosure.

That act—the 2007 Mortgage Forgiveness Debt Relief Act—exempts taxpayers from as much as $2 million in forgiven debt. But the debt had to be acquired before Jan. 1, 2009—and had to have been used solely to buy, build or remodel/repair a primary residence.

The government’s new, expanded modification programs include short sales, in which a bank agrees to accept as full payment less than the value of the mortgage balance; deed-in-lieu transactions, when a homeowner gives the house to the bank instead of repaying the mortgage; and second mortgages such as home-equity lines of credit.

In many of those instances, say Treasury officials, homeowners used mortgage money to fund everything from tuition and medical bills to vacations and cars and even the down payment on a second home or investment property. That debt, however, isn’t eligible for exemption.

Sometimes the tax bills are so high that people can’t afford to pay. In such a situation, the IRS will allow taxpayers to apply for an installment-payment plan.

Some homeowners can avoid the taxes completely if they can prove insolvency, in which the total value of debt exceeds total assets. But even that could leave some owing taxes.

IRS rules stipulate that a taxpayer can escape taxes up to the extent of insolvency, meaning that if one’s liabilities are $500,000 and assets are $300,000, the $200,000 difference is the extent of the insolvency. But if the person has $250,000 in debt canceled, then $50,000 is taxable income.

“People think their house was underwater, so they’re insolvent and can get out of owing taxes,” says Arthur Auerbach, a member of the Individual Income Tax Technical Resource Panel at the American Institute of Certified Public Accountants. “But it doesn’t work that way.”

By NICK TIMIRAOS, Wall Street Journal

Fannie Mae will make it easier for some struggling homeowners to buy houses in the future if they avoid foreclosure in the present.

Under rules released this month that will take effect in July, some troubled borrowers who give up their homes by voluntarily transferring ownership through a “deed in lieu of foreclosure” or by completing a short sale, where a home is sold for less than the amount owed, will be eligible in two years to apply for a new mortgage backed by Fannie.

Currently, borrowers who complete a deed-in-lieu of foreclosure must wait four years before they can take out a loan that Fannie is willing to purchase.

In 2008, Fannie lengthened that waiting period to five years from four.

To quality for the reduced waiting period, most borrowers will need to make a down payment of at least 20%, although borrowers with extenuating circumstances, such as a job loss, will be required to put down just 10%.

Even if waiting periods are shortened, many borrowers may be unlikely to repair their credit that quickly in order to get a loan in the first place. Foreclosures and short sales generally have the same effect on a borrower’s credit score and can stay on a credit report for up to seven years.

The new rules are designed to make foreclosure alternatives more attractive to borrowers at a time when the Obama administration is ramping up its effort to encourage banks to consider alternatives such as short sales. That program sets pre-approved terms for short sales and offers financial incentives to borrowers and lenders to complete such sales.

Freddie Mac requires borrowers to wait five years after a foreclosure and four years after a short sale or deed-in-lieu.

Those periods can fall to three years for a foreclosure or two years for a short sale when borrowers show extenuating circumstances.

Officials at the Federal Housing Administration, the government mortgage insurer, say they are considering changes to their rules, which require borrowers with a foreclosure to wait at least three years before becoming eligible for an FHA-backed loan.

“We are beginning to think about post-recession, how you address borrowers who became unemployed through no fault of their own … and now deserve the right to re-enter the housing-finance system,” said FHA Commissioner David Stevens.

But some worry that policies enabling defaulted borrowers to more quickly resume homeownership could encourage more people to default.

“We don’t want to say that there’s a ‘get out of jail’ card during recessions to walk away from your house,” Mr. Stevens said.

In December, the FHA unveiled rules for borrowers who completed a short sale.

Those who have missed payments prior to completing a short sale or who didn’t face a hardship and simply took advantage of declining market conditions to buy a new home must wait three years.