Archive for August 14th, 2012

Expiration of the Mortgage Debt Relief Act … Is it a Problem?

In recent weeks, many clients have asked that I share my views about the impending expiration of the Mortgage Debt Relief Act of 2007.  It’s probably past time that I do so.

To understand how this works, one has to first understand what a deficiency is.  The best way to explain that is to give an example.  Suppose the total amount you owe your bank is $300,000, but the house is worth only $125,000 when the bank forecloses.  (Unfortunately, that type of ratio is common nowadays.)  Many homeowners are willing to “walk away” from that house, and understandably so.  Unfortunately, however, the law, at least in Florida, generally entitles the bank to pursue collection of the entire $300,000 that is owed to it, even though the house is worth just $125,000.  The extra $175,000 – the difference between what is owed ($300,000) and what the house is worth ($125,000) – is called a deficiency.

Many homeowners can accept that a foreclosure may happen at some point, but they don’t want to get foreclosed and still owe the bank money.  They want the deficiency to be waived.  Sometimes, banks are willing to do so, particularly if the homeowner consents to a foreclosure.  That sounds great – the $175,000 owed is no longer owed!  But here’s the problem.  Even if the bank agrees that the homeowner doesn’t owe that $175,000, the Internal Revenue Service may treat that $175,000 as income.  In the IRS’s eyes, forgiving $175,000 of debt is the same as that homeowner earning $175,000 in income, so that homeowner has to pay taxes on the $175,000.  Depending on your tax bracket, that could necessitate a payment of $45,000 or more – a prohibitive amount for anyone, especially homeowners in foreclosure.

To help the economy, our government passed a law (one of the few that has actually helped middle class America during foreclosure-gate) called the Mortgage Debt Relief Act of 2007.  Basically, it says that when a bank forgives a deficiency on a homeowner’s primary residence, the debt forgiveness is not taxable.  Hence, in my example above, if the bank is willing to waive the $175,000 deficiency, the homeowner doesn’t have to pay the $45,000 in taxes to the IRS.

Sounds good, right?  Well, here’s the problem there.  The Act is set to expire at the end of 2012, and it’s unclear whether it will be extended.  This has caused many homeowners to openly wonder:

Should I try to get a deficiency waiver now, while the Mortgage Debt Relief Act is still in effect?

I certainly see the logic in this.  However, I generally think that concerns of these types are overplayed – not the sort of thing that should be driving a homeowner’s decision-making process with respect to his/her residence (generally speaking).  Here’s why.

First, the Act has been extended before, and I’d be surprised if it’s not extended again.  Remember, this is an election year.

Second, the Act only applies if we’re talking about a homeowner’s primary residence.  So if we’re not talking about debt on your primary residence, the expiration of the Act does not affect you.

Third, even if we’re talking about your primary residence and even if the Act is not extended, there’s another significant exception to a homeowner’s obligation to pay taxes upon a deficiency waiver – insolvency.  If you’re insolvent, as defined by IRS Code, then you have no tax liability on any deficiency waiver.  What does it mean to be “insolvent”?  I’m no tax expert (and anyone in this situation should seek advice from an accountant).  However, it’s simpler than it sounds – you’re insolvent when your total debts exceed the total fair market value of all of your assets.  Yes, “assets” includes everything you own, but if we’re talking about someone facing foreclosure on their primary residence (which, by definition, we are) then many homeowners don’t have many assets, so they’ll fit the bill.  Just think about it.  Using my example, above, if your house is worth $125,000 and you owe $300,000 and you’re getting foreclosed on that house, you’d have to have at least $175,000 in other assets – without any other debts – not to be insolvent.

For example, suppose you have no other debts and have $25,000 in the bank, $100,000 in IRAs and 401(k)s, two vehicles worth $20,000, and your furniture and all other personal property is worth $25,000.  That would be far better than most homeowners I’ve encountered in this type of situation – most have many other debts (e.g. credit card debts) and not nearly that much in the way of assets.  (Bear in mind, your personal property may be worth a lot to you, but the fair market value of the used possessions in your house is probably much less than you think.)  Anyway, using those numbers, that’s $170,000 in assets, plus the $125,000 house, for a total of $295,000 – still less than the $300,000 in debts, so you’d still be insolvent, so you’d have no tax liability.  Think about that – someone with no debt except the house and $170,000 in other assets is still deemed insolvent for purposes of owing taxes on the deficiency waiver.

If you’re trying to figure out if you are insolvent, but aren’t sure because you don’t know how much you owe or what your house is worth, bear this in mind … the amount you owe is almost always greater than what you think.  By the time the bank includes the bogus charges, costs, and fees they always include, plus 18% default interest, the amount owed is invariably higher than most homeowners realize.  (Fortunately, this is one time where it pays to owe more, and the banks’ crooked inclusion of bogus charges actually helps.)  As for what the house is worth, just go to – it typically provides a decent estimate.

So if you’re insolvent, whether the Act is extended is irrelevant – you won’t owe taxes.

Fourth, I’m going to share the way I’ve handled this situation on many occasions.

Under the IRS Code, tax liability flows from a deficiency waiver because of debt forgiveness.  The term “waiver” says it all – the bank is “waiving” its right to collect the deficiency, and by waiving the homeowner’s obligation to pay, the bank is forgiving the debt.  That debt forgiveness is what creates tax liability under IRS Code.  Deficiency waiver = debt forgiveness = tax liability.

But what if there was no obligation to pay the deficiency in the first place?  What if there was no entitlement to a deficiency at all?  As I see it, if there’s no entitlement to a deficiency, then there’s no “waiver,” no debt forgiveness, and, hence, no tax liability.  No deficiency waiver = no debt forgiveness = no tax liability.

How is that possible?  How could that be?  It’s actually quite simple.  Mortgage foreclosure cases – at least the ones in my office – are contested.  We contest the amount of the debt and we challenge the bank’s entitlement to anything at all, much less the full amount sought.  When we’re making these challenges, this can easily create a situation where the parties are willing to compromise – by entering a Final Judgment of Foreclosure, one which waives the deficiency.  We consent to a foreclosure, and the bank agrees to waive the deficiency … everyone wins.  Except I don’t call it a ”waiver,” as it’s not a “waiver.”  Instead, I want that Final Judgment to say “Plaintiff is not entitled to a deficiency against any defendants.”

The distinction may appear subtle, but I think it makes all the difference in the world.  Think about it.  If a Final Judgment says Plaintiff is “not entitled to a deficiency against any defendants,” then how could there be any tax liability?  No entitlement to a deficiency = no debt forgiveness = no tax liability.

How can this argument possibly fly?  For me, it’s a compilation of factors.  First, we are challenging the debt – both the amount owed and that creditor’s right to collect.  The Final Judgment represents a compromise of that settlement.  We don’t think we owed that bank anything, but to resolve the dispute, we’ll agree we owe the bank the house – but nothing else.  When both sides agree that is all that was owed, and there was no deficiency, how can the IRS possibly disagree?  In that same vein, if the court which presided over the dispute rules that the bank is not owed a deficiency, and the parties so agreed, how can the IRS possibly disagree?

I suppose the IRS might disagree, and might try to pursue a claim for taxes.  But guess what that means?  In my view, that means they’d have to prove that XYZ Bank, as Trustee for the ABC Trust (or whatever alphabet soup trust was suing for foreclosure) was actually entitled to more money than the house was worth.  After all, for the IRS to be owed anything, they’d have to prove debt forgiveness, which would require proof that the homeowner owed more to that plaintiff than the house was actually worth.   Now, think about that for a minute … the banks themselves are having a miserable enough time as it is proving what they are owed.  Do we really think the IRS is going to try to start proving what these banks were/are owed?  I don’t.  I’m certainly skeptical, anyway.

If this sounds like a cheap lawyer trick, think about it like this … there are many, many instances (not just in foreclosure cases) where parties disagree about the amount owed.  Reaching a compromise of that dispute is routinely encouraged … in many walks of life.  I suppose it’s possible, but it’s hard for me to imagine that the IRS will start going behind an agreement of the parties, and a Final Judgment of a court, and take the position “even though the parties agreed and even though the court ruled there was no debt forgiveness, there actually was debt forgiveness, so you owe taxes.”

Is this foolproof?  Probably not.  But do I like it?  Absolutely.

Fifth … if somehow all of that doesn’t work, there’s always bankruptcy.

So there you have it, folks.  Do I hope the Mortgage Debt Relief Act is extended another year (or more)?  Yes.  But even if it’s not extended, should everyone be petrified that they’ll owe a bunch of money to the IRS?  I’d say no.  Chances are, you’re either insolvent, can file bankruptcy, or can settle the dispute in a way that won’t create any tax consequences.

Might I be wrong?  Sure, maybe.  Can this work out for 100% of the people reading this?  Probably not.  But what’s the alternative?  In case you didn’t realize, it’s not exactly easy to get a bank on the phone to try to agree to a short sale (with a deficiency waiver), especially quickly.  So don’t fret.  There are ways around a deficiency short of owing the IRS a bunch of money.

Mark Stopa

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