A question was posed to me and I thought it would make great blog discussion.  Here is the question and my response is posted below.  What do you think?

Q- The second loan on top of the original mortgage wiped out most of the equity long before the condominium was listed for sale three months ago.  Recent price reductions reduce what little equity was remaining, yet the drop from $500,000 to $460,000 still has not attracted buyers.  The monthly loan payments are difficult for the owner who is convinced she should walk away, giving the property back to the bank.  What would you tell her?  What are the tax, financial, and personal implications of defaulting on the loans?

A- Walking away is certainly an option but not one that I would necessarily recommend. From a tax perspective, should the lender agree to a short sale, any “forgiven” loan amounts could be reported as taxable income to the IRS on a 1099, resulting in a large tax liability (with some exceptions; consult your tax advisor for more details and guidance); a foreclosure is more damaging to a personal credit profile than a short sale (neither of which are particularly good), so exploring a short sale would be worthwhile, provided it could be made to work for all parties.

The damage to the seller’s personal credit report would follow her for a number of years, although some mortgage lenders would potentially look past it in a couple to a few years’ time depending on other credit factors. 

Obviously, the best solution would be to sell the property as listed and try to extricate the owner from the situation. A short sale or a foreclosure should be the last resort for any seller. In some cases, selling to a “fast cash” type of organization may be an option, but any sale would likely be far below market value and the seller may walk away without any profit (but this would still be better than a foreclosure or a short sale in most cases). 

Any discussion about a short sale or foreclosure should be handled by an agent or broker with knowledge of the ramifications from a real estate perspective, and clients should be strongly advised to seek competent tax and/or legal advice for ramifications involving either or both areas.