For Immediate Release - March 30, 2011

Victims of 2010 Morgan Stanley Case to Receive Additional Tax Relief From IRS

AG obtained favorable tax guidance from the IRS on consumer mortgage principal reductions

BOSTON - The Internal Revenue Service (IRS) has released a written determination that will significantly help victims of the subprime mortgage crisis covered by the AG's settlement with Morgan Stanley, Attorney General Martha Coakley announced today. Under the 2010 settlement, over 700 consumers received principal write downs on their loans. The IRS determined that these write downs are not "gross income" for the consumers bringing the consumers within a safe harbor for loan modifications created by Congress to protect victimized borrowers from increased taxes.

The Attorney General's case against Morgan Stanley, resolved last year, resulted in Morgan Stanley paying $102 Million for its role in the subprime lending crisis in Massachusetts. The Attorney General alleged, in part, that Morgan Stanley facilitated the sale of unfair subprime loans to Massachusetts borrowers. As part of the settlement, Morgan Stanley paid approximately $58 Million to benefit Massachusetts borrowers who allegedly received predatory loans.

Most of the $58 Million is being used to directly pay down the balances of existing consumer loans. This principal reduction addresses the unfairness of the loans, and enables the consumers to get out from under debt that often exceeds the value of their dwellings. Once the homes are no longer considered "under water," consumers can either refinance into new loans, or afford better loans going forward.

"The IRS' determination protects consumers and ensures that the Massachusetts homeowners benefiting from the Morgan Stanley settlement will receive the full relief they deserve," said AG Coakley.

As part of the AG's settlement with Morgan Stanley, the Attorney General sought the assistance of the IRS in clarifying that the principal reductions would be excluded from gross income of the borrowers. After reviewing the matter, the IRS issued a written determination that the principal reductions accomplished by payments from the Morgan Stanley settlement fund to loan holders or services on behalf of borrowers would not be considered "gross income to borrowers under §61 of the Internal Revenue Code…" The IRS last Friday made the written determination public.

The IRS clarification may also help pave the way for other principal reduction settlements. While the written determination notes that it "may not be used or cited as precedent," it may still provide a starting point and touchstone for other discussions with the Internal Revenue Service regarding principal reduction settlements.

"We remain committed to addressing all facets of the subprime crisis," said AG Coakley. "I am hopeful that this will not just help the consumers in the Morgan Stanley case, but can also give some direction to enforcement agencies seeking to help consumers in Massachusetts and around the country."

Historically, mortgage principal reductions of a loan by a lender were often considered taxable income by the federal government. Given that consumers obtaining a principal modification were usually in difficult financial straits, calling these modifications "income" meant the consumers could be hit with devastating tax bills just when they had gotten their financial matters in order. Congress addressed this problem in 2007, by passing the Mortgage Forgiveness Debt Relief Act of 2007, extended by the Emergency Economic Stabilization Act of 2008. Now, certain qualifying mortgage principal reductions are excludable from taxable income.

However, it was unclear whether the new law applied to situations where a government enforcer required payments to provide principal reductions to remedy unfair lending practices, or whether it would only apply in situations where the consumer worked out a qualified principal reduction on his or her own. Given that many banks were vigorously resistant to modifying mortgages, Congress' new standard might have a very limited effect if it didn't also protect consumers who were helped by enforcers such as State Attorneys General. Moreover, many of the lenders behind the subprime crisis are out of business. The tax status of settlements with other entities that could reduce the principal on the mortgages-such as investment banks that had facilitated the unfair lending practices-was unclear under the new law.

This matter is being handled by AG Coakley's Insurance and Financial Services Division.