Short Sales, Bankruptcy & the Expiration of the Mortgage Debt Forgiveness Act

17972-20131021The Mortgage Debt Forgiveness Act of 2007 is no longer with us.  While there is still hope that the Act may be renewed when Congress comes back into session in January its expiration means we have to take a look what the real estate market will look like without the Act.  For the person facing a short sale, deed in lieu of foreclosure or a foreclosure this means a world without any good options and a bad situation that could stick with them for years.

The Mortgage Debt Forgiveness Act of 2007 was enacted to address the tax consequences of debt forgiven as the result of a short sale or deed in lieu of foreclosure.  The Act was a temporary measure intended to deal with the problems facing homeowners as a result of the collapse in home values at that time.  After a some prior extensions the Act expired December 31, 2013.  The Act allowed a person to excluded from income up to $2 million in forgiven debt if that debt was the result of an original mortgage for a principal residence. Regulations interpreted “original” to include debt that was incurred to acquire or improve that person’s principal residence.  This still meant that the  Act did not cover investment properties or the forgiveness of mortgage debt that was incurred as the result of a debt consolidation or for purposes other than home improvement.  Since these people had to  deal with forgiven debt without protection from the Act we have a pretty good idea of what option people will have now that the Act has expired. (As an aside take a moment to think about the $2 million cap.  Isn’t that ridiculously high? How would anyone have that much debt forgiven?) 

Whenever a person is dealing with issues involving a short sale, deed in lieu or foreclose they almost always need to consult with a tax advisor, a real estate agent and a lawyer.  In a post Mortgage Debt Forgiveness Act world the tax advisors role is more important than ever.  This team is important so that the homeowner can understand their options and make a decision as to which of their options is best for them.

Whenever you ad a tax issue to a situation you know you have just made things more complicated.  Since a short sale is already a complicated process with to many parties involved, adding a tax issue can only make this worse. Because of the limitations in the Mortgage Debt Forgiveness Act, even if the act is extended anyone doing a short sale or deed in lieu of foreclosure should be consulting with a tax advisor about their situation.  The last thing you want to do is get a huge 1099-C around tax time and then start to try to figure out if you are going to have to pay taxes on that amount.  

One of the first concepts to deal with is how can debt become income.  To deal with the seeming illogic of this, forgiven debt is often referred to as phantom income.  While the concept that debt becomes income may be counterintuitive it isn’t as mysterious as the term “phantom income” makes it sound.  When you borrow money you don’t have declare it as income.  If think of the loan as income the forgiveness of this debt being counted as income is not so hard to understand.  Since you would just deduct the payments as you paid the loan back the system is kept a simpler by not counting the loan as income.  To make up for this when the debt is forgiven you have to declare the amount of loan that you are not paying back as income now that it is forgiven.

When someone forgives debt over $600 they are required to send a 1099-C.  The person who had the debt forgiven then has to report it on their tax return and  pay income tax on the amount forgiven, or to try to exclude that amount from income.  While we are lawyers even we have someone do our taxes, so as they say on television consult your tax advisor before making any decision based on this information.  The website for IRS has a ton of information.  In fact the main fault with their site may be how hard it is to sort out the information you need from all the stuff that doesn’t apply, but it is a great place to start when researching your options.

For someone facing this situation the options are fairly limited, and the choice involved figuring out which of these bad options would be best for them.  Since you don’t have a good option it is important to figure out which of the bad options will let you put this situation in the past the fastest.  This is far from simple and can vary greatly depending on your particular circumstances such as the amount of debt being forgiven, income level, tax bracket and even the type of security clearance your job may require.  Since part of what you are trying to figure out is how fast you can bounce back from this situation it also involves guessing what the further will bring.  Since you cannot predict the future the next best thing to do is to look at things from a risk benefit analysis.  With each option you should imagine what life look like if things go better then you expect, and what will your life look like if things go worse.  To do this a person facing this situation has to have a solid understanding of all these options so they can make the decision that is best for them.

The main option for avoiding taxes now will be the insolvency exclusion.  The problem is that to meet this exclusion you have to show that your were insolvent at the time the debt was forgiven and you have to include as part of your calculation assets that are normally beyond the reach of creditors such as retirement accounts.  If you are facing the possibility of paying a large amount of taxes on forgiven debt this probably isn’t the year to try to do your taxes yourself.  In fact it may be the year that it is worth the money on at least consulting with a CPA about your situation.

People who have mortgage debt forgiven and are not able to meet the test of insolvency may find themselves going from a mortgage problem to an income tax problem.  However this is usually better then if the debt isn’t forgiven.  If you short sale your home and still owe $100,000.00, the mortgage company could get a judgment and collect that money by a garnishment.  This could leave you paying for a house for a very long time.  If you get a 1099-C you don’t owe that amount that was forgiven, you owe the taxes on that amount of income.  In this situation you may be surprised how reasonable the IRS can be about working out a payment plan.  But that still could put your life on hold for quite some time and could cause you other problems, and owing money to the IRS is never a good thing.  Because of this, without the the protection of the Act, some sellers in short sale may prefer to focus on negotiating a reasonable payment plan on the balance rather than asking for forgiveness of the debt.

If this debt is large enough, or as is often is the case the person is dealing with other debt, another option to consider is bankruptcy.  Since debt discharged in bankruptcy does not count as income filing a bankruptcy may be the quickest way to bounce back from debt that is going to be forgiven.  This is particularly true if there is other debt the person is dealing with along with the mortgage problem.  To avoid the income tax problem you need to file the bankruptcy case prior to the taxes coming due on the forgiven debt.  Usually this means filing for bankruptcy before April 15th of the year that the taxes are due for the year the 1099-C is issued.  Since it is much harder to discharge tax debt it is important to explore this option before tax season is upon you.  To decide if bankruptcy is the best option a person would need to know what type of bankruptcy they can file and how long that case will last.  For most people this will mean either a five year payment plan in a Chapter 13 bankruptcy or a Chapter 7 bankruptcy that could be discharged in less than 6 months.

Where the homeowner is in the foreclosure or short sale process is an important factor in deciding when to file the bankruptcy.  Since any sale during  the bankruptcy would have to be approved by the Court, if there is a pending short sale contract it may be best to wait to file the case.  If the property is subject to a Home Owners or Condo Association fee   it may also be best, if possible to wait for the sale or auction to be completed.  While arrears can be discharged the property owner remains responsible for post filing fees until their name is removed from the deed.  To avoid having a property owner from having to pay Condo fees for a property they have surrendered in bankruptcy it may make sense to let a foreclosure auction or short sale to be completed before filing a bankruptcy.  If the owner is going to pursue a short sale but has not yet even listed the property for sale it make make sense to go ahead with the bankruptcy.  If the person is able to get a Chapter 7 discharge the post discharge short sale may actually be easier as the forgiveness of the debt is no longer an issue.

Even when the Mortgage Debt Forgiveness Act was in place many homeowners would get frustrated and overwhelmed with the problems facing them.  Without the Act in place their situation is made worse and the road to recovery may be even longer.  Unfortunately we have seen many people who couldn’t take advantage of the Act when it was in place simply ignore the problems and hope they would go away.  Some give up on a short sale and let the house just go to foreclosure, others faced with a tax liability stop filing tax returns.  Needless to say doing this only makes matters worse.   This will also have an impact on the real estate market as a whole.  Each person this happens to means one more person who will not be in the market to buy a house for quite sometime.  It could also mean one more bank owned property on the market.  If this happens to enough people the expiration of the Act could have a negative impact on the housing market for years to come.  Maybe this is why investors are putting so much money into rental properties.

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