From the November 2007 issue of Wealth Manager Web • Subscribe!

November 1, 2007

The Foreclosure Trap

The newspapers have all tolled the sad news: As house prices flatten or decline throughout most parts of the country, more borrowers become "upside downers" -- real estate jargon for people who owe more on their mortgages than their dwellings are worth. Unfortunately, this is not just an economic problem; it's a tax problem, too.

There are potentially severe tax consequences for borrowers in arrears on mortgage payments for personal residences. Internal Revenue Code Section 108 targets upside downers with scant or no equity in their homes. It snares the ones who walk away from falling prices and higher borrowing costs and thereby force their lenders to foreclose on the properties.

In these circumstances, lenders who foreclose or repossess commonly cancel or forgive debts. Usually, this means debtors must report cancelled or forgiven amounts as income on Form 1040. Code Section 108 does make several carefully hedged exceptions--one being for insolvency. And legislation has been proposed that would end debtors' liability for income taxes on cancelled or forgiven amounts.

But for the time being, here is an example of how current law punishes debtors: In 2005, Andrew and Beverly Brown bought a condo for use as their principal residence. The couple's $300,000 payment included a $15,000 down payment and a $285,000 mortgage loan on which they were personally liable. The Browns became unable to keep up their monthly payments. Refinancing was not an option for them because their home was now worth less than they paid for it, and their current credit is too weak for them to qualify for another loan. Worse yet, they could not sell the property for enough money to pay off the remaining $280,000 that is owed to the lender bank, Last National (LN).

Fortunately for the Browns and other upside downers, lenders looking to minimize losses want borrowers to stay in their homes and not default on loans. Lenders usually lose lots of money on foreclosed dwellings because of costs incurred to maintain and then sell such properties--often at significant discounts.

To hold down foreclosures, lenders offer workout deals or loan modifications known as "mods" that ease normally reliable borrowers through rough patches. Mods typically provide for lower interest rates or stretch out the payment terms. But LN won't even go that far because it believes the Browns are unlikely to meet their payments even after a mod.

Still, LN can pursue other ways to avoid foreclosing on the Browns. One tactic is a "deed in lieu of foreclosure"--an arrangement that requires a defaulting borrower to voluntarily transfer title to the property to the lender. Typically, the lender relieves the borrower of any further liability for the unpaid balance of the debt--even when the net sales price (gross sales price minus legal fees, broker's commission and other costs) is insufficient to cover all of the outstanding debt.

Another way is for LN to authorize the Browns to enter into a pre-foreclosure "short sale" --the term for a sale where the loan exceeds the sales price. The Browns' short sale nets $230,000--$50,000 less than the $280,000 due. LN cancels their debt of $280,000 in exchange for the sales proceeds of $230,000.

The debt does not enter into the Browns' calculation of the loss. Using the numbers in the example, the short sale causes them to incur a loss of $70,000, the excess of their condo's adjusted basis of $300,000 (assuming no subsequent improvements were made that increased the basis) over its sales price of $230,000.

The tax code prohibits write-offs for losses on sales of personal residences. For the Browns to garner any kind of deduction, their loss must be on the sale of property held for investment or business reasons.

But the Browns are in for more bad news. LN's cancellation of the remaining $50,000 of the outstanding debt of $280,000 means they have to declare reportable income of $50,000--the amount by which the $280,000 exceeds the $230,000.

The denouement: LN sends the couple and the IRS a Form 1099-C. It shows debt cancellation of $50,000, reportable as "other income" on line 21 of the 1040 form and taxed at the rates for salaries, pensions and other kinds of ordinary income.

In my experience, homeowners like the Browns usually are unaware of any possible tax consequences until they open envelopes that contain 1099-C forms. By then, it is well after the close of the year in question and too late for them to undertake any tax planning.

The proposed legislation, officially titled "The Mortgage Cancellation Tax Relief Act of 2007" (H.R.1876 and S.1394) and introduced this past April, authorizes relief for home owners in financial trouble. No longer would they have reportable income from cancellation or forgiveness of debt on mortgages secured by principal residences. The relief is prospective only; it takes effect as of the date of enactment, meaning the date the President signs the legislation. It is unlikely that the proposal will be modified to authorize retroactive relief for the many individuals like the Browns, who are liable for taxes, interest charges and penalties.

Julian Block is a syndicated columnist and author based in Larchmont, N.Y. who also conducts CE courses for financial planners and other professionals. For information about his books, go to ww.julianblocktaxexpert.com.

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