What’s positive about being foreclosed upon or selling your home for less than you owe?  Well, for most people, not much.  Yes, you are relieved of an onerous mortgage loan and you are now free to find housing that is more affordable within your budget.  But not everyone fully understands the lingering effects of a foreclosure as it pertains to the mortgage debt forgiveness.  This applies to foreclosures, short sales and a deed in lieu of foreclosure.

Foreclosure can be one of the most devastating things a homeowner can face.  At a minimum, they will end up with damaged credit.   Until recently, the tax laws further penalized homeowners who were relieved of mortgage debt obligations with additional taxation.  Homeowners owe taxes on the amount of the debt obligation from which they are relieved.  For example, let’s look at a short sale.  If a bank agreed to accept $200,000 as payment in full to satisfy a mortgage where the homeowner owed $250,000, the homeowner would owe taxes on $50,000.  They were relieved of repaying $50,000 in mortgage debt.  When you are relieved of debt, you are actually benefiting because you no longer have the obligation to pay it back.   Hence you must pay tax on this “unrealized income” even if there was no direct corresponding benefit, such as equity proceeds from a sale.  At the same time, how is the homeowner who just lost everything going to be able to pay tax on the differential of the satisfied mortgage obligation when they received no tangible proceeds from the sale? 

As we have just seen, the amount of debt forgiveness is considered income.  All debt forgiveness, not just mortgage debt, results in reportable taxable income.  Many people who’ve walked away from their homes have found this out the hard way.  Many found out at the end of the year when they opened their mail and found they’d received a 1099C.  The 1099C is the IRS form that the creditor gives the debtor when they have forgiveness of debt. 

Today we have a record number of foreclosures.  When banks and lenders sell homes they’ve gotten back during the foreclosure process they are less concerned about the bottom line and more concerned about being rid of the collateral.  This can result in spiraling downward values in areas or communities where foreclosures are high.  Large numbers of foreclosures like we are currently experiencing are hurting our overall real estate market valuations.

One solution to the problem has been to encourage those homeowners in distress to work with the bank to sell the home while they continue to occupy the property.  This may result in a short sale, whereby the bank agrees to accept less than is owed on the outstanding mortgage.  Together, the bank and homeowner work to sell at the highest possible price given the conditions of the prevailing market.  Working together allows the home to be maintained and occupied during the course of the sale.  This generally is less costly to the lender and is one of the reasons why they entertain short sales. 

In general, short sales are less “shocking” to the market values in comparison to a lender going through the foreclosure process and then reselling the property as an REO.  This should be encouraged where possible.

Tax wise, homeowners still receive a 1099C.   From a credit report perspective, the lender usually won’t report a foreclosure against the homeowner if they sell with a short sale.  A short sale in that instance will be beneficial to the seller’s credit and may be helpful when the seller becomes a buyer and wants to obtain another mortgage in the future. 

In Minnesota we have a unique situation regarding foreclosures.  For owner occupied properties, we have a 6 month right of redemption from the date of the Sheriff’s sale.  Because of the long redemption period, during which no payments are due, many in Minnesota are opting to be foreclosed upon instead so they can live in the home for free.  You see this occurring most often where preservation of a one’s credit rating is no longer important to the homeowner. 

To encourage lenders and homeowners to work together, the government has just created a new law.  The law is H.R. 3648, entitled Mortgage Forgiveness Act of 2007 and was signed into law as of mid December 2007.  Here’s what the law does:  it waives taxes for debts forgiven from the beginning of 2007 to the end of 2009.  This means no more 1099C, at least during this time frame. 

Can you see the implications?  This means that homeowners and lenders can work together to either sell or refinance the existing mortgage debt, without having to recognize the taxes due on the amount forgiven.  It provides an incentive to protect your credit and work out an acceptable solution, such as a short sale.  Income taxes are taken out of the equation since there isn’t anymore inherent tax liability from mortgage forgiveness. 

This should slow down the foreclosure crisis and allow values to stabilize.  This is a good law that should help ease the mortgage and real estate crisis we are facing today.