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Your Options If You Have an Underwater Mortgage

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So, You Have an Underwater Mortgage…


A mortgage foreclosure can damage your credit for up to seven years.  Even if you do not anticipate buying another home during those seven years, you may still need a decent credit score to rent a home or even get a job.  Are there are options other than foreclosure for an underwater homeowner who is seeking relief?

 Options If Your Mortgage is Underwater

Deed in Lieu of Foreclosure: You voluntarily give the deed back to the bank.  This option is available only if you have only one mortgage loan – no second mortgage and no home equity line of credit — and the bank agrees.

Short Sale:  The bank agrees to accept a purchase price where proceeds from the sale are less than the mortgage liability amount.  Any unpaid balance is a deficiency which the borrower may or may not be liable for.  All lien holders including  any mortgage insurer must agree to the terms of a short sale.

 Pros and Cons

It is the borrower that initiates a “deed in lieu of foreclosure”.  By doing so, the borrower avoids the stigma of a foreclosure while the lender avoids the time and expense involved with repossession.  The lender may be willing to accept the real property to satisfy the loan amount in order to simply preserve the value of the property or to minimize the risk of even further loss in the event of a subsequent bankruptcy where multiple creditors are vying for a limited amount of assets.

A short sale may be acceptable to both the borrower and the lender in that it limits additional fees and expenses for both.

Both of these options affect your credit, but perhaps not as much as a foreclosure.

Both a short sale and a foreclosure may  result in income tax liability.  First, you must understand the difference between recourse and non-recourse debt.

 Recourse vs. Non-Recourse Loan

A non-recourse mortgage loan is a debt that is secured by a pledge of the underlying real property as collateral, and for which the borrower is not personally liable.  If the borrower defaults, the lender can seize the collateral, but the lender’s recovery is limited to the collateral.  The result is that non-recourse debt is typically limited to 50% or 60% loan-to-value ratios.  12 states are “non-recourse” states — Alaska, Arizona, California, Connecticut, Idaho, Minnesota, North Carolina, North Dakota, Texas, Utah, and Washington.

A recourse mortgage loan does not relieve you of liability — even after you have forfeited the collateral that secured the loan — if there is a deficiency between the amount you owe and the value of the collateral.  Refinances, second mortgages, and “cash out” loans are often recourse loans.

 Taxability of Debt Forgiveness

Calculating any taxable gain from the discharge of mortgage debt starts with an understanding of adjusted tax basis.

A homeowner’s tax basis is the home’s original purchase price (including the amount of original debt assumed) plus the cost of any improvements made to the property.  If the amount realized exceeds the amount of adjusted tax basis, there is a gain.  If the amount realized is less than the adjusted tax basis, there is a loss.

Foreclosure Example:

  • Real property has a mortgage liability of $100,000, adjusted for the lender’s foreclosure expenses.
  • The appraised value of the real property is $85,000.
  • The homeowner’s adjusted tax basis is $50,000.

If the mortgage is a recourse loan $85,000 is used as the imputed “selling price” to calculate a $35,000 ($85,000 less $50,000) gain on the sale or disposition of personal residence real property.

If the mortgage is a non-recourse loan the $100,000 mortgage loan balance is used as the imputed “selling price” to calculate a $50,000 ($100,000 less $50,000) gain on the sale or disposition of personal residence real property.

If the loan is a recourse loan and the debt is forgiven, the taxpayer will realize $15,000 ($100,000 less $85,000) of taxable ordinary income — COD or cancellation of debt income.

If the loan is a non-recourse loan there is, by definition, no taxable COD income.

Short Sale Example:

  • Real property has a mortgage liability of $100,000.
  • The net sales price for the real property is $85,000.
  • The homeowner’s tax basis is $50,000.

If the mortgage is a recourse loan $85,000 is the selling price used to calculate a $35,000 ($85,000 less $50,000) gain on the sale or disposition of personal residence real property.

If the mortgage is a non-recourse loan the $100,000 mortgage loan balance is used as the imputed “selling price” to calculate a $50,000 ($100,000 less $50,000) gain on the sale or disposition of personal residence real property.

Generally, lenders do not grant any relief to short sellers with a recourse loan.  The $15,000 deficiency — $100,000 mortgage liability less the sales proceeds of $85,000 — is still payable by the borrower to the mortgage lender.  However, if the lender does forgive some or all of the debt, the forgiven amount is taxable cancellation of debt (COD) income – unless the mortgage is non-recourse loan.

But note that the taxability of principal residence gain is subject to the principal residence tax exclusion break.  A single taxpayer can exclude up to $250,000 of gain, and married/joint taxpayers can exclude up to $500,000.  To qualify, you must have owned and used the home as your principal residence for at least two years during the five years ending on the date of the sale.  Mortgage losses on principal residences, however, are not tax deductible.  You can only claim a tax loss on business or investment property.

Recourse vs. Non-Recourse Loans

The most important factor in determining the tax consequences of a foreclosure or short sale is the type of mortgage – recourse vs. non-recourse loans.

Non-Recourse Loan – There may be a taxable gain or non-deductible loss on the disposition of the property; but there will never be a tax bill based on the cancellation of debt because the property value is deemed sufficient for cancelling the debt.  In a foreclosure or a short sale, the imputed sales price for calculating a gain or loss is equal to the outstanding mortgage balance adjusted for foreclosure fees.

Recourse Loan – If the lender forgives part of the debt, there may be a taxable gain or non-deductible loss as well as cancellation-of-debt income for tax purposes.  However, there are some beneficial tax-law exceptions that may apply to the COD income.   In a foreclosure or a short sale, the sales price amount for calculating gain or loss is equal to the fair market value of the real property  — the appraisal value for a foreclosure and the net transaction price for a short sale.

 

State tax laws vary.  Your state income tax liability may not be calculated the same.  Get professional advice.  Various experts are available and highly recommended for homeowners facing a foreclosure or contemplating a short sale – attorneys, CPAs, real estate brokers specializing in short sales, non-profit organizations, and government agencies.  Do, however, be cautious about using private debt negotiators who charge a fee for their service.

Image(s): FreeDigitalPhotos.net


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