By Marcene Poss Powell, EA
In 2005, Ginger and Pepper Spicely were house hunting. They were married for 10 years, and had two children and a dog. Their careers had them moving up the ladder of success and with that move, nice incremental pay increases. Their family had grown to the point they had outgrown their rented apartment, they wanted something larger, and they thought they were now in a position financially of affording the American dream - a home of their own.
As prudent purchasers, their first stop was a mortgage broker's office. The broker had been highly recommended to them by friends who recently purchased their first home. The mortgage broker took their financial information, ordered a credit report, and crunched the numbers to see what price house this couple could afford. Ginger and Pepper had been very prudent in their saving plan and had built a rather sizable savings account that would be used as their down payment. They left the office of the mortgage broker with a pre-qualification letter in hand which stated they could afford a home in the range of $200,000 to $210,000.
Pepper had a roommate in college who was in real estate and had told them to call him whenever they were ready to purchase a home. Pepper called him, described what type of home in which they were interested and gave him the pre-qualification amount obtained from the mortgage broker. The sales agent told Pepper he would do a search of homes for sale in the area and would get with him within two days. The agent called Pepper and told him he had located ten different homes that fit the criteria. He gave Pepper the MLS numbers of the homes, instructed him to look them up on the Internet and see if any of them appealed to him and Ginger.
Ginger and Pepper had a very enjoyable time viewing these homes and could narrow the search to three that they wanted to physically visit. Their agent set the appointments and they were off to see the houses that would become home. Their choice was everything they had wanted and more. The price of the home was a little under the pre-qualification amount so everything was in place. They made an offer on the home, the seller accepted it, the mortgage loan was approved, and a closing date was set. The Spicelys moved into their new home within six weeks. Another American Dream had been realized!
However, fast forward this story to the spring of 2008. Pepper developed some health issues. He had excellent health insurance coverage at his job but his illness progressed to the point that he could no longer work. He had disability insurance but the amount of monthly payment was significantly less than he had made previous to the illness. Medical bills, the costs associated with having a catastrophic illness, and his impaired income were seriously affecting the Spicely's ability to financially keep their heads above water. In the summer of 2008, Pepper passed away.
Prior to Pepper's death, they had already experienced some delinquency on their home mortgage. They were not current on this large payment but they could keep the wolves from the door. Now with Pepper's passing, the disability insurance was no longer available. The couple had been living on virtually only one income for so many months the bills were now staggering.
Distraught with losing Pepper coupled with this monumental debt, Ginger decided she needed to sell her home and get out from under this debt and payment. She called Pepper's roommate who had assisted them with the purchase of their home to assist her in the sale. She and the children could move in with her parents and with the huge mortgage debt off her shoulders, she thought she could provide some quality of life that was acceptable.
When Pepper's friend arrived at the home to discuss the sale, he had very bad news for Ginger. Although she had heard about the burst in the housing bubble, she had not realized about the effect it would have on her desire to sell. The agent had performed due diligence in developing a probable price he thought the house would bring on the market. Because of the state of the housing industry, Ginger was shocked that the price he was quoting was considerably less than the outstanding indebtedness on the house! With the number of buyers at an all-time low, if they could find a buyer what about the difference in the sales price and the balance due on the mortgage. Not knowing what to do, Ginger decided to let the mortgage lapse into foreclosure. She had no one to advise her on what to do but she knew this would kill her credit score. However, her score had been drastically affected because of the massive bills incurred during Pepper's illness.
Ginger stopped making any attempt to pay the mortgage payments. After several letters explaining the results of her action, the mortgage company foreclosed. Ginger and the children were safe in the home of her parents and they began trying to piece their lives back together. She had no idea what was looming ahead.
This is a story of a family who did everything right but was still caught in this economic era called a recession. The definition of a recession is a period of declining incomes and rising unemployment. A depression is a severe recession.
Near the end of January 2009, Ginger received a document from her mortgage company that appeared to be some type of income tax document. The document was a 1099-C Cancellation of Debt. Unfortunately for Ginger, she had not consulted with any type of tax professional relative to her problems or her decision to allow the mortgage company to foreclose on her property. She called an enrolled agent recommended to her and set up an appointment for a consultation.
The EA explained to Ginger that foreclosure is treated as a sale that may realize a gain or loss. If the outstanding loan balance is greater than the fair market value of the home and the lender cancels all or part of the remaining loan balance, you realize ordinary income from the cancellation of debt. This amount must be reported on a tax return unless exceptions apply.
A qualified principal residence indebtedness exclusion is available if the mortgage taken out is to purchase, build, or substantially improve your home. This loan must be secured by the main home of the borrower. Qualified principal residence indebtedness also includes any debt secured by this main home that is used to refinance a mortgage taken out to buy, build, or substantially improve a main home, but only up to the amount of the old mortgage principal just before the refinancing.
This exclusion is named The Mortgage Forgiveness Debt Relief Act of 2007. This act generally allows taxpayers to exclude from income the discharge of debt on their principal residence. Debt reduced through mortgage restructuring as well as mortgage debt forgiven in connection with a foreclosure qualifies for the relief. This debt relief applies to debt forgiven in 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). This exclusion does not apply if the reason is for any reason other than a decline in the home's value or the taxpayer's financial condition.
Ginger was saved from the necessity of claiming this discharge of indebtedness as income on her tax return because of the Mortgage Forgiveness Debt Relief Act of 2007. But this exclusion must be reported on Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness). She will check box 1E for qualified principal residence indebtedness exclusion and put the amount of discharge on line 2.
If Ginger could have sold her home even at a loss, in lieu of foreclosure and the lender forgave the balance, it is still eligible for the Mortgage Forgiveness Debt Relief Act. The lender will issue a Form 1099-C Cancellation of Debt showing the amount of debt forgiven. As long as the debt was for qualified principal residence indebtedness, she was insolvent immediately prior to the discharge or if the debt was canceled in a title 11 bankruptcy case, it qualifies.
The United States Government has estimated that by the end of 2010, over fifty percent of home owners who have a mortgage on their home will owe more than the home's value. This is referred to in recent housing articles as being "underwater."
On April 14, 2010, an FHA Refinance Option for Underwater Borrowers and Revisions to the Home Affordable Modification Program (HAMP) was announced by Assistant Secretary of Housing David H. Stevens to a hearing before the Subcommittee on Housing and Community Opportunity U. S. House Committee on Financial Services. This program will permit lenders to provide additional refinancing options to homeowners who owe more than their home is worth because of large falls in home prices in their local markets. These adjustments will provide more opportunities for qualifying mortgage loans to be responsibly restructured and refinanced into FHA loans as long as the borrower is current on the mortgage and the lender reduces the amount owed on the original loan by at least ten percent.
There is also a second lien write-down program that will further assist homeowners in reducing the negative equity in their homes. This program is designed to better assist responsible homeowners who have been affected by the economic crisis. These programs are being underwritten by TARP (Troubled Asset Relief Program) and will not exceed the $50 billion originally allocated for housing programs.
Whereas loan modifications can offer short term solutions, unfortunately nearly all of these home owners will be unable to qualify for any debt forgiveness. Many homeowners, like Ginger, do not know what their options are. Homeowners are cashing in retirement accounts, using credit cards to pay bills, and borrowing money from relatives just to keep their heads above water.
A new term that has entered the mortgage loan industry in recent years is a short sale. Simply put, a short sale is a sale of real estate in which the sale proceeds fall short of the balance owed on the property's loan. This answer to homeowners "underwater" occurs when a borrower cannot pay his or her mortgage loan and the lender decides to sell the property at a moderate loss or to allow the borrower to sell at a moderate loss. Both the borrower and the lender must agree to this short sale process. It saves the lender from foreclosure costs and curtails the damage to the borrower's credit history. It can be handled faster than a foreclosure and is less expensive. However, it does not eliminate any remaining balance on the loan unless agreed upon by both the lender and the borrower.
Most large banks or mortgage companies have loss mitigation departments that evaluate the proposal to determine if it is in the best interest of the lender to participate in such an arrangement. The lender will determine how much equity is available (if any) by the use of a broker's price opinion or an appraisal. Due to the present overwhelming number of underwater homeowners, lenders are more amenable to accept short sales than previously.
These short sales differ somewhat from a foreclosure in that a foreclosure is an action taken by the lender. In a short sale, both parties must agree. A buyer of a short sale property may be in jeopardy due to either the lender or the borrower changing his or her mind at any time prior to the execution of the deed.
Credit implications of a short sale are significantly less than that of a foreclosure. According to the Distressed Property Institute, short sales do not show on a credit report. If the borrower is current at the time of the sale, a new mortgage is possible after one to three years of a short sale. Compared to a foreclosure in which a credit score can be affected by as much as 300 points, the short sale is a better option. A foreclosure will remain on the credit report for as long as ten years and is permanent in the public records of the county in which the property is located. An employer, whether presently or in the future, has the right to check credit if you are in a particularly sensitive position. A foreclosure is one of the most negative items on a credit report and could affect any future employment. On any federally-mandated standard loan application Form 1003, you are asked specifically if you have had property foreclosed on or given title or deed in lieu of within the past seven years. This affects the interest rate given on any future loans.
As part of this continuing cycle of a depressed housing market, tax professionals need to be poised and ready to counsel clients in all facets of debt and its forgiveness. The challenge to the problem has been met head-on by government leaders. The directives issued by the Department of Housing and Urban Development (HUD) have proven to be very instrumental to thousands of homeowners through the restructure of debt. Several programs are available to the homeowner--such as HAMP--that provides for a lower and more affordable monthly payment, drastic interest rate reduction, principal reductions, elimination of fees and penalties, and stopping foreclosures instantly. But these programs do not eliminate tax consequences when a creditor writes off or settles a debt.
In summary, when a lender has written down or canceled debt, it results in a 1099-C being issued to the former borrower. Any financial institution that forgives or writes off $600 or more of a debt's principal must send this 1099C. The IRS views this as income, meaning the borrower may owe income taxes. Hopefully, this article has provided you with substantial information on how to handle a discharge of indebtedness. If this discharge, whether by foreclosure, short sale, or deed in lieu of foreclosure, is handled correctly, a tax professional can totally eliminate any taxable consequence or at the least, lessen the consequence of this situation. Americans are experiencing an unprecedented number of "underwater" homeowners. As our nation awaits this economic crisis to end, if you are a tax professional, arm yourself with knowledge to assist these homeowners in a stressful situation. A majority of the time, it is not the fault of the homeowner; he or she has been caught in this recession/depression through no action on their part.
Marcene Poss Powell was awarded the designation of enrolled agent by the IRS in 1992. She owns a tax and accounting firm in a small town in East Central Georgia and has been preparing taxes for over twenty-five years, specializing in small business returns. Additionally, she is both a Georgia and South Carolina real estate broker and is a certified residential real estate appraiser.
Reprinted from EA Journal, courtesy of the National Association of Enrolled Agents.