Owner’s Choices: Short Sale versus Foreclosure

March 14, 2009 by  
Filed under Short Sale How To

foreclosure-70One of the most important functions of a short sale expert is to help troubled property owners look at the available choices. Do not push the short sale, it might not be the best choice for the owner. Here is what you need to know to let the seller make an informed choice when comparing a short sale to a foreclosure.

Foreclosure does have an advantage. In most states, it is swift and certain, just like an execution. After the sale on the courthouse steps and the expiration of any redemption period or time for an upset bid by another buyer, it is over and the house is no longer the former owner’s responsibility. The owner does not have to deal with keeping the property in good condition, dealing with repair issues that come up in a sale and the warranties that go to the buyer after a sale.

In North Carolina, the foreclosure procedure has an unusual feature of a 10 day period after the sale where anyone can upset the successful bidder at the sale. So, when the bidder walks away from the sale on the courthouse steps, no sale has actually occurred. If no one bids during this ten day period, the original bidder gets the property. If someone bids, the ten day period starts all over again, so other upset bids may make the process continue. So, in North Carolina, it is not swift and certain as it can be a slow death. The one thing to know about the ten day upset bid period is that the former owner still owns the property, so you can complete a short sale after the “sale” on the courthouse steps but before the upset bid period ends.

In comparison, the short sale may take a while to get a buyer and a period of time for the lender to approve it. Then, there is additional time for the buyer to close the sale.

The disadvantages of a foreclosure start with the emotional effects. It is not pretty to have the children see the house posted and watch the sheriff throw the family out. All the neighbors know. Theoretically, you do not get to arrange time to move gracefully, as you have to be out when the sheriff says so. On a practical basis, the REO Realtor who is going to market the home after the foreclosure will probably offer the family two weeks to move out, and a little money to help in the move called Cash for Keys (or CFK).

In contrast, a short sale allows the family to stay in the home until the closing of the sale and move out in the normal manner.

The second disadvantage is to your credit report and future loan applications. A foreclosure causes one of the largest hits to your credit score. Under Fannie Mae guidelines, you will not qualify for a loan for at least five years, and probably seven years. You will have to answer the questions on loan applications saying you have had a foreclosure within the last seven years, which will almost automatically get the loan declined.

On the other hand, a short sale causes a smaller hit to the borrower’s credit report. You can try to get the loan reported as “paid as agreed” to have the effect on the credit score minimized, but it not common that you will succeed. The answer to the questions on future loan applications about foreclosures or giving a deed in lieu of a foreclosure is no, so your loan is not automatically declined.

A third disadvantage is that you do not get to negotiate a settlement of any balance due on the loan. In states like West Virginia, North Dakota, Montana, Mississippi, Minnesota and California, this is not a factor as state law prohibits a “deficiency judgment” i.e. a judgment that you owe the balance of the amount that the lender did not get paid in the foreclosure. The rule is complicated in California, because deficiency judgments are prohibited if the lender forecloses using a “power of sale” in the deed of trust (which is the vast majority of foreclosures), but it is not prohibited if the lender forecloses by going to court (even though there are other laws that prohibit deficiency judgments even if the lender goes to court). In other states, banks can chase the borrower not only for the balance of the loan, but for the attorneys fees and other charges that were incurred in the foreclosure. It does take extra attorneys fees to get the deficiency judgment and collect it, so many lenders do not bother to do this. But it is possible the lender can sell the deficiency to a collection agency and they will make the borrower’s life miserable.

One of the advantages of a properly negotiated short sale is to get a full release of the obligation. In other words, in return for the short payment, the lender releases the obligation in writing so that there is a complete settlement of the debt. After this release, there is no remaining balance due. You cannot guarantee a seller that you can accomplish this, as some lenders will refuse to do this. You can guarantee that you will try.

The fourth disadvantage of a foreclosure may be tax consequences. The rules for the “non-recourse” states of West Virginia, North Dakota, Montana, Mississippi, Minnesota, and California are complicated, so consult your tax advisor, particularly in California where the IRS seems to say that they treat sellers there like the “recourse” states for some situations and not for others. If it is truly non-recourse situation, there are no tax consequences of a foreclosure. For the rest of the states, you look at the IRS forms that tell you to start with the amount of the debt right before the foreclosure and add the attorneys fees and other costs to that debt. Then, you subtract the fair market value of the property (which means you get to argue about whether the amount paid at the foreclosure sale was the fair market value, which it usually is not because fair market value is a willing buyer and seller with neither one under any undue pressure and I think foreclosure is the ultimate in undue pressure). The difference is usually taxable, unless you qualify for one of the exemptions in the Internal Revenue Code. In short, the difference between what you owed and the fair market value of the home is taxed as income tax, and the lender will send you a form 1099 A or 1099 C to specify the size of the tax consequences.

Both a foreclosure and a short sale may qualify to be non-taxable under The Mortgage Forgiveness Debt Relief Act of 2007. The tax consequences of a short sale are discussed in detail in another post “Income Tax and Short Sales”, and the rules are similar for a foreclosure. If the debt relief is not excused by the recent legislation, the short sale will normally cost less in taxes, as the house typically sells for more in a short sale than a foreclosure sale, so more of the debt is paid off. Also, the cost of the foreclosure sale is added to the debt in a foreclosure sale, so the amount owed is larger than in a short sale possibly resulting in worse tax consequences.

The tax consequences of a short sale, a foreclosure and a deed in lieu of foreclosure are all similar because all three of these are considered a sale by the IRS. You have the normal tax consequences of a sale, so if you had a gain on the sale, you own tax on it. Internal Revenue Code section 121 exempts the first $250,000 in gain for a single filing taxpayer, and $500,000 for taxpayers filing jointly, so unless there is a large gain, there is no tax consequence.

Every now and then, a foreclosure is better for an owner than a short sale. But, the vast majority of the time, the short sale is preferable.

Income Tax and Short Sales

February 23, 2009 by  
Filed under Short Sale How To

internal-revenue-building-70x70One of the problems with a “short” sale used to be that a seller had to pay income tax on the amount the payment was “short”. So, if you owed the bank $300,000 and you paid back only $250,000 when the sale closed, the $50,000 that you are short is taxed as ordinary income. That phantom income of about $50,000 could cost you $14,000 to the IRS and more to the state taxing authorities.

The Mortgage Forgiveness Debt Relief Act of 2007 was signed into law eliminating the income tax for some sellers whose sales close between January 1, 2007 and January 1, 2010. There are several requirements:

1. The property sold must be your principal residence, as defined in section 121 of the Internal Revenue Code.

2. The debt that is forgiven must be “Qualified Principal Residence Indebtedness”, i.e. the money used to acquire a principal residence.

3. There is a limit of Two Million Dollars for the amount of non-taxable Debt Forgiveness, a limit that will not affect the vast majority of homeowners.

These rules raise some questions. The biggest one is what is Qualified Principal Residence Indebtedness. The law says “For purposes of this section, the term `qualified principal residence indebtedness’ means acquisition indebtedness . . . with respect to the principal residence of the taxpayer.” So, if you refinanced the house for more than what you owed and took money out to spend on other things, that additional amount is not covered by this law. For example, you had a loan of $200,000 when you bought the house. You refinanced it with a loan of $400,000, and used the additional money to pay off your other debts. If you sell the home and pay $350,000 instead of the $400,000 debt, this new law does not protect you from paying income tax on the $50,000 that was “short”. If you take out a mortgage to buy the house, refinance it for the amount owed on that mortgage (and no more), then your payment to pay off the mortgage is $50,000 short, you will not pay tax on that amount.

Another question is do you need to have lived there for 2 years out of the five years before your home is sold, as that requirement exists to establish a home as your principal residence in order to avoid paying tax on the gain when you sell your primary residence. This question comes from the reference in the law to section 121 of the internal revenue code, which is normally used to eliminate tax on a home where you made up to a $500,000 profit when you sell it. To qualify for that exclusion from tax, you have to live in the house for 2 years out of the five years before you sell it. It does not make sense to impose that requirement based on the purpose and intent of the legislation, but there is a lot of the Internal Revenue Code that does not make sense. For example, this law was designed for people who bought a home with financing and did not pay back that same financing that was used only to buy the home. If someone is forced to live in the home for years before they are excluded from the income tax on a short sale, it defeats the purpose of the legislation. Also, the longer someone lives in a home the more likely it is that there was a “cash out” refinance, and failing to pay back the cash that you got out of the homes is taxable under this new law.

A property that is purely an investment property does not qualify for the exclusion from taxes if you sell it short. But, a property can be rented for a while and still be your principal residence, so it could qualify. Under section 121 of the IRC, if you lived in the home for two years, then rented it for up to three years, then you sold it, it is still your principal residence. So, if you sold it short in this situation, you may qualify for the exclusion. New legislation restricts this provision, so that the time your rent the property decreases the amount of the deduction.

One more question is what happens if you refinance the home and use the additional funds to remodel the home. Normally, that would increase your basis in the home, so it would decrease your tax liability if you sold the house. So, it would be logical to allow this type of refinancing to be subject to the protection of the new law. Again, it is hard to rely on logic when dealing with the IRS, so I hope there are some regulations developed to interpret this situation. The new pamphlet “Tax Relief For Struggling Homeowners” says that the Act “applies only to forgiven or canceled debt used to buy, build or substantially improve your principal residence”, so the term “substantially improve” implies that a refinance where the money goes into remodeling the house would be covered by this Act.

It is possible to qualify for a partial exclusion from tax. If some of the debt that was not paid back was for money used to buy your principal residence, that part is not subject to income tax. So, you buy a home with a mortgage of $200,000, you refinance it for $250,000 and use the other $50,000 to pay off your credit card debts. Then, you sell the home and do not pay back $75,000 of the mortgage. The first $50,000 that is not paid back is subject to income tax. The last $25,000 that is not paid back is not taxable.

The amount of forgiven debt that is not taxed is subtracted from the basis of your next house, so that when you sell it, you have to recognize more gain on that sale. For example, you go short by $75,000 when you sell a home, you buy another one later for $400,000. Your basis is not $400,000, but $325,000 as the $75,000 is subtracted from your basis. So, when you sell it, you will have $75,000 more gain. Remember, there is an exemption from tax for $500,000 of gain for a married couple filing jointly, so this amount of additional gain could be covered by this exemption. Even if it is not, if you make more than $500,000 in gain and have to pay some tax, you should not cry.

It is hard to find the text of the law, but here is a link to how it looked when it passed, so you can click here read it for yourself. http://tinyurl.com/2qdnwj . Also, you can look at the information available with IRS Form 982 that a taxpayer must file even if all of the forgiven debt is covered by the Mortgage Forgiveness Debt Relief Act so that there is no tax due. Another source of information is the instructions for IRS form 1099-c that is filed by the bank to tell the IRS how much debt was forgiven. The seller will receive a copy of form 1099-c by January 31 of the year following the sale that will specify the amount of the debt that has been forgiven.

This law is new enough, and in need of interpretation, that if you find yourself in this situation, you need to consult a tax professional before you sell.

So, for people who bought a home, did not refinance it for more, and sold it for less than they owed, there is no income tax due on the short sale, so long as the payment on the mortgage is less than two million dollars short. This legislation eliminates one of the most miserable parts of a short sale, as it was obnoxious for a homeowner to loose all their equity, have to sell their house, and then get a tax bill.

There are other provisions of the Internal Revenue Code that forgive the income tax that could be due on forgiven debt if the taxpayer is insolvent. The IRS Tax Relief for Struggling Homeowners pamphlet says “Normally, a taxpayer is not required to include forgiven debts in income to the extent that the taxpayer is insolvent. A taxpayer is insolvent when his or her total liabilities exceed his or her total assets.” If the seller wants more information, refer to the instructions for IRS Form 982 that goes in to other ways to exclude forgiven debt.

Do not try to be a tax professional for your sellers. If you are a Realtor, you sell real estate, you do not give tax advice. If the seller wants to know about the tax consequences of a short sale, refer him to this post for general information. When my sellers want specific answers to their individual tax questions, I refer them to Richard deButts of Jewell, deButts & Roberts, PLLC , because he has experience with short sales. Do not hesitate to refer your seller to competent tax advisors, first because they will get quality advice and secondly your errors and omissions insurance probably does not cover any mistakes you might make giving tax advice.

One other practice that will protect you from liability is to put a contingency in the contract similar to “this contract is contingent on Seller’s apporoval of the tax consequences of this sale within 10 days of the execution of this contract. Seller is advised to consult a tax professional.” If you have a contingency in the contract for the seller’s review and approval of the tax consequences, there is conclusive proof that the understanding of the tax consequences is an important part of the contract, as the contingency gives the seller the right to terminate the contract if the owner is unhappy with the tax consequences. A similar method to protect yourself is to advise the owner in writing that they must consult a qualified tax professional and putting hold harmless and indemnity provisions in that document so that if the owner later decides that there is a misunderstanding concerning the tax consequences, you are indemnified (financially protected) by the owner against any liability.

The IRS just published a pamphlet that will explain many of the tax issues in a short sale. Click here to get a copy of it. If the sellers ask you tax questions, one of your simplest ways to answer them is to refer to the pamphlet, and give them a copy with your listing materials as you refer them to a qualified tax professional.

Short sales require a wide variety of talent. You thought a regular sale was interesting. Now, you can have a more complicated sale that raises issues from the nearly impossible to read Internal Revenue Code. Just be careful and you can help our financial crisis by getting distressed homes sold.

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