Understanding Foreclosure Deficiencies and Mortgage Debt Forgiveness: Specific, Clear, Detailed Examples Given
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This article discusses the tax consequences of what happens when your home is foreclosed on, when you do a short sale, or you do a deed-in-lieu of foreclosure and there is a deficiency. Issues covered include:
Can your lender sue you for any deficiency owed;
What happens if the lender forgives the debt;
When/if you owe taxes on a deficiency;
How much you may owe in taxes;
When you won’t owe taxes;
And a whole lot more. So, let’s get started . . .
Why So Many Homeowners are Facing Foreclosure Deficiencies
The foreclosure crisis hit in earnest in and around the fall of 2007. Its effects continue to this day. One of those effects has been than many owners find themselves upside down on their real estate homes and/or investments. When the property is sold, whether voluntary or involuntary, this shortfall needs to be addressed one way or another and the effect of same can have substantial financial impact.
What Does It Mean to Be “Upside Down” on Your Home?
Being “upside down” means that the amounts owed on all loans on your property — determined at a specific time and in a specific manner — exceeds the value of your property. This “value” of your home can change depending on whether the calculation is being made as a part of a deed-in-lieu, a short sale, or a foreclosure.
What Happens When You Do a Deed-In-Lieu of Foreclosure Transaction?
In a deed-in-lieu transaction, the owner transfers the property to the lender in satisfaction of the mortgage encumbering the property. If the lender determines that the value of the property in question is less than the mortgage debt, a deficiency arises.
Example of a Deed in Lieu of Transation: Let’s say the lender is owed $329,000.00 at the time of the deed-in-lieu transfer date. Let’s further surmise that the lender has determined that the value of the property is only $270,000.00. This means a deficiency of $59,000.00 would exist ($329,000 – $270,000 = $59,000).
Example of a Short Sale Transation:In a short sale, the deficiency is determined based on the net proceeds received by the lender at the time of the sale.
Using the numbers from the example above, if the property is sold for $270,000, the net proceeds given to the lender will be substantially less. Assuming a 6% real estate commission and traditional closing costs (documentary stamp tax, title insurance and tax credits), the net proceeds to a lender on the sale will likely be less than $250,000. This would result in a deficiency of over $79,000.00. Here’s how the math shakes out:
Lender Owed: $329,000
Property Sells for: $270,000
Realtor Commission: $16,200
Closing Costs: $4,050 (FYI, closing costs are usually between 1-2% of the sales price. We calculated this at 1.5%, so in this case it’s $270,000 x 1.5%, which equals $4,050).
So the final “loss” to the lender doing a short sale is $59,000 (cause house sold for $59,oo0 less than what was originally owed on it) + 16,200 + $4,050 = $79,250, for a final net of $249,750.
Post Continued Below . . .
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Deficiencies in a foreclosure are judicially determined after the foreclosure sale. If a lender is seeking a deficiency (ie, going after the homeowner for the “net loss” on the property), the lender must apply to the court and provide appraisal information to support the valuation.
The property owner has an opportunity to challenge the valuation by submission of evidence to support a higher valuation. At the deficiency hearing, the court determines the property’s value as of the foreclosure sale date and then calculates the amount of the deficiency.
For Property Owners: Choices You Have If There Is a Deficiency
If a deficiency exists, there are several possibilities that a property owner might face depending on what the lender chooses to do with regard to the shortfall. This includes debt forgiveness, collection by the lender or sale of the debt to a third party for collection.
What Happens if You Have 1st and SEcond Mortgages On Your Property and a Deficiency Exists
In addition, in many cases, an owner will have a first and second mortgage on their property. Generally the second mortgage lender gets little or no money, and may take action separate and apart from the action of the first mortgage lender, even if the loans are titled in the name of the same lender (most loan holders are servicing agents who may own a portion of or none of the actual loan and the actual owners may direct that different action be taken on each loan).
What Happens When a Lender Forgives Your Debt (ie, Doesn’t Sue You for the Deficiency)
If the lender elects to forgive the indebtedness, the lender will send the property owner a Federal tax Form 1099-C. This is notice to you from the lender that the debt is cancelled and no collection effort will be made on the debt. The amount of the debt forgiven is determined in the same manner as the deficiency. Cancelled debt is generally treated as taxable ordinary income to the recipient of the debt relief unless some exception applies.
Example of Debt Forgiveness by a Lender: For example, if a property is foreclosed and the final judgment amount is $450,000.00, and the property has a value of $400,000.00 at the time of the foreclosure sale, the debt forgiveness will be $50,000.00. This $50,000.00 will be taxable income and treated as if someone paid you the actual money even though you did not receive any payment. If your blended tax rate is 20%, you would owe $10,000.00 in tax on this amount.
Debt Forgiveness Could Mean You Owe Taxes on the Deficiency Amount, But . . .
There are several exceptions to the taxability of the loan debt forgiveness. However, it is crucial that a Form 982 be filed with a tax return to make sure that the debt cancellation is addressed, regardless of whether the debt relief is taxable.
When You DON’T Have to Pay Taxes on Mortgage Debt Forgiveness
The most common exceptions are as follows:
1. Qualified principal residence indebtedness: This is the exception created by the Mortgage Debt Relief Act of 2007 and applies to most homeowners.
2. Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
3. Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your total assets.
4. Non-recourse loans: A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property used as collateral. That is, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income.
The Mortgage Forgiveness Debt Relief Act of 2007
The Debt Relief Act of 2007 was created to address the growing number of foreclosure on property for which the mortgage debt exceeds the value of the property. Effective for the tax year 2007 and valid through 2012, the Debt Relief Act allows homeowners to be exempt from taxation for debt forgiveness for loans up to two million dollars (one million for married couples filing separately) which secured the taxpayer’s primary residence.
Restrictions on The Mortgage Forgiveness Debt Relief Act of 2007
The Debt Relief Act has certain restrictions which may affect if any tax due as follows:
1. Only the debt given to acquire, build or substantially improve the residence is exempt. People who cashed out their equity via a refinance will only have a partial exclusion. For example, if the home was originally financed with a $300,000.00 loan, refinanced with a new loan for $400,000.00 in a cash out, and the value at foreclosure is $250,000.00 the taxpayer will have $50,000.00 in exempt income and $100,000.00 in taxable income.
2. The Debt Relief Act only applies to an owner’s primary residence. Second homes, rental property, vacation homes and investment property are excluded and debt relief on these properties will result in taxable income, unless another exception applies.
In order to obtain the exception, a taxpayer must complete new IRS Form 982 to evidence the debt forgiveness and to calculate the exemption amount. According to the IRS, in most cases the application under Form 982 only requires that a few lines be completed to obtain the appropriate relief.
As part of the debt forgiveness process, a careful examination of the amount forgiven and the value of the home listed on the 1099-C should be checked, especially if tax liability exists. If these figures are incorrect, the lender should be notified and an attempt to obtain a revised 1099-C should be made. If the lender refuses to make the corrections, you should consult a tax professional for assistance in challenging the 1099-C amounts with the IRS.
What Happens If Your Lender Does Not Forgive Your Mortgage Debt
If the Lender does not forgive the indebtedness after foreclosure, short sale or deed-in-lieu, then the deficiency becomes an unsecured obligation of the maker on the note.
In a foreclosure action, a deficiency is created by judicial determination. After the foreclosure sale, the lender applies to the court for a deficiency based on the value submitted by the lender. A property owner can challenge this valuation at the deficiency hearing by presenting evidence (appraisal or comparables) to support a higher value. At the hearing the court then determines the amount of the deficiency and awards the lender a judgment based on that amount.
If the deficiency arises from a short sale or deed-in-lieu, the lender must bring an action on the note against the maker, seeking the shortfall. As part of this process, a challenge to the amount due can be made. At the end of the lawsuit, the lender obtains a judgment against the maker under the note and can begin collection proceedings. In next month’s article we will discuss deficiency judgments and collections.
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About the Author: Michael J Posner, Esq., is a partner in Ward Damon, a mid-sized multi-specialty business oriented law firm serving all of South Florida, with three offices in Palm Beach County. They specialize in real estate law, and can assist owners with foreclosures, short sales, deficiency hearings and loan modifications. They can be reached at 561.842.3000, online at http://www.warddamon.com/, or via e-mail at email@example.com. His blog is located at http://floridarealestateattorney.blogspot.com.