With the country in the midst of a national housing market crisis, many homeowners have found themselves in the precarious position of owing more on their houses than they are currently worth. The lagging job market and high unemployment rate have left some families unable to afford their house payments, especially if their monthly payment increased after their adjustable mortgage underwent a rate adjustment. Even though the Memphis housing market did not suffer as badly as others, there were still more than 3700 foreclosure filings in Tennessee in November.
There is a lot of misinformation about the options available to homeowners who are behind on their mortgage payments and facing probable foreclosure, particularly concerning the advantages and disadvantages of short-sales over foreclosure as well as the risks and benefits of filing for bankruptcy. Below you will find information on each option. For more information on how each option may benefit your situation, contact an experienced attorney.
In a short sale, the homeowner sells his or her house for less than what is owed on it in hopes that the lender will accept this amount in satisfaction of the mortgage debt. Short sales often are pursued by homeowners who are upside down in their mortgages and unable to continue making their monthly payments.
The lender, however, is under no obligation to agree to the terms of a short sale. Lenders are less likely to accept a short sale if the homeowner has other assets that can be sold to pay off the debt. If the lender does not agree to the terms, then the homeowner must still repay the difference between the sale price and what is owed on the mortgage. Otherwise, the lender can secure a judgment against the homeowner for the remaining unpaid debt.
If the lender does agree to the short-sale, it can have important tax consequences for the homeowner. When the lender accepts less than what is owed on the mortgage in satisfaction of the debt, the lender will submit a 1099-C form to the IRS for the debt discharge. The amount of the debt discharge, known as "debt discharge income" (DDI), then becomes taxable income for the homeowner.
For example, if the homeowner owes $500,000 on the mortgage and the house sells for $400,000, the $100,000 difference between the sale price and mortgage becomes debt discharge income and the homeowner can be taxed on it.
Many homeowners, however, will be protected from paying federal income taxes on debt discharge income related to a mortgage under the Mortgage Forgiveness Debt Relief Act of 2007. This federal law exempts $1,000,000 for single filers and $2,000,000 for joint filers for forgiven mortgage debt so long as the mortgage was originally taken out to acquire, build or improve a principal residence. The exemptions under the Act were set to expire on December 31, 2009, but have been extended until the end of 2012.
It is important to note that the Mortgage Forgiveness Debt Relief Act only applies to federal income taxes. It does not apply to Tennessee state income taxes, which may include any forgiven mortgage debt as part of a homeowner's taxable income.
In a foreclosure, the bank or other lender will repossess a house from a homeowner who has fallen seriously behind in their mortgage payments. The lender then will sell the house in satisfaction of some or all of the mortgage debt. Depending on the type of mortgage the homeowner has, the sale of the home will either satisfy the mortgage debt in whole or the lender will be able to seek payment from the homeowner for any difference between what is owed and what is ultimately earned in the sale of the house.
Homeowners can have a recourse or non-recourse mortgage. In a recourse mortgage, the homeowner is personally liable for the debt, even if the lender repossess the home through a foreclosure action. This means that if the house is sold via foreclosure and the lender does not receive the full amount owed, then the lender can seek any unpaid amounts from the homeowner. Second mortgages generally are recourse mortgages.
In a non-recourse mortgage, the house is the only security for the loan. If the lender forecloses on the home, their only option to recoup some of their losses is to sell the house. The lender must accept whatever amount it receives for the sale of the house in satisfaction of the debt. It cannot go after the homeowner for any remaining unpaid debt. Many first mortgages are non-recourse mortgages, but not all.
Like short sales, foreclosures can have important tax consequences for the homeowner. If the homeowner had a recourse mortgage and the lender decided to forgive any remaining unpaid debt, this amount would be discharged debt income and taxable to the homeowner. Just like with short sales, the homeowner would be eligible for the exemptions under the Mortgage Forgiveness Debt Relief Act for federal tax purposes, but would still be subject to state tax on the income.
The homeowner can also be taxed on any gain earned from the sale of the house, even in foreclosure. Whether there is a gain also depends on whether the mortgage was a recourse or non-recourse mortgage and whether the sale of the house netted the homeowner more than the adjusted cost basis of the house. Conversely, homeowners are not allowed to write-off any loss on the value of their residential property. This is only allowed for business and investment properties.
Thus, simply allowing a home to go into foreclosure may not alleviate all of the homeowner's financial woes.
For some homeowners considering a short sale or foreclosure, bankruptcy actually may be their best option. If they want to keep their home and can afford to make some payment on their mortgage, a Chapter 13 bankruptcy may be a good fit.
In a Chapter 13, the debtor will submit a repayment plan to the bankruptcy trustee that will include repayment of the mortgage debt. So long as the debtor makes all of the payments under the repayment plan (generally a 3 to 5 year period), then the bankruptcy court will discharge any remaining debts at the end of the repayment period. The Chapter 13 may allow the homeowner to restructure their mortgage debt and, in some cases, may allow them to pay back less than they owe while still keeping their house.
Homeowners who have too much debt and will not be able to stick to a repayment plan may want to file a Chapter 7 bankruptcy. In a Chapter 7, the debtor liquidates his or her assets and uses the proceeds to repay creditors. In many cases, the debtor will not have any or only minimal assets to liquidate to repay their debts. The bankruptcy court then will discharge all of their debts and the debtor will receive a "clean slate" to start over.
Chapter 7 bankruptcy does not allow homeowners to keep their homes, but it may give them the extra time they need to strike a deal with their lenders. In both Chapter 7 and Chapter 13 bankruptcies, the court will issue an automatic stay that prevents creditors from collecting any further debt pending the bankruptcy action. This includes foreclosure actions. Although the lender can petition the court to lift the stay regarding a foreclosure action, the time the foreclosure is stayed may give the homeowner the time he or she needs to make new arrangements with the lender.
Unlike in short sales and foreclosures, bankruptcy does not result in debt discharge income for federal or state income tax purposes. Once the debt is discharged through a Chapter 7 or Chapter 13 filing, the debtors do not have to worry about creditors coming after them for any remaining unpaid debt on their homes, credit cards or other discharged debt.
It is important to note, however, that not all types of debt are dischargeable in a bankruptcy, including student loan debt, unpaid child and spousal support and certain unpaid taxes.
Seek Experienced Legal Advice
Before making any decision, homeowners should speak with an experienced attorney. The attorney can review their specific situation and more thoroughly explain the pros and cons of foreclosure, short-sale and bankruptcy. The lawyer can also explain the anticipated state and federal tax consequences and help the homeowner plan accordingly.
While some homeowners may believe they do not need an attorney's advice before going forward with a short sale or foreclosure, it is important that the homeowner understand all of the potential consequences of going forward with either option. It is much easier for an attorney to advise a homeowner on the best option for their situation before any decision is made rather than to come in afterward and try to fix a bad result.
For more information, contact an attorney experienced in taxation and bankruptcy law today.