Ask A Tax Professional Before Losing or Walking Away from Your Home

By Denice A. Gierach – May 13, 2010

These days in this shaky economy and what the experts are calling the “jobless recovery,” there are many people still out of work. Perhaps the reader of this article has friends or family that are currently out of work, but have been actively seeking work. There is not enough money coming into the family’s budget to continue to pay a large mortgage that was paid when the principal person working had a great job. Maybe, it took two incomes to make that mortgage payment and now there is only one income, or worse yet, both husband and wife are not working. The couple has tried to sell the house, but there are just no buyers out there who want to pay an amount equal to or greater than the amount of the mortgage. What are the options?

One option is to do a short sale. The borrower gets the best price out of the buyers out there, making the contract subject to approval by the lender. Then the borrower has to convince the lender to agree to a contract with a price that is less than the existing mortgage. This can take months, as banks traditionally have been reticent to accept the lower amount, despite the fact that the bank would receive less if the house were sold through a foreclosure sale. If the bank does agree to the short sale, the balance of the mortgage above the sale price is “forgiven.”

Another option is to get the bank to accept a deed in lieu of foreclosure. In that case, the borrower may have tried unsuccessfully to sell the home (even for an amount less than the outstanding balance of the mortgage). The borrower may offer to the bank to give the home back to the bank, using a deed in lieu of foreclosure, in return for which the bank may “forgive” the balance of the debt above the market value of the home.

There have been an increasing number of people who move and leave the keys in the door, abandoning the property, not making any deal with the bank. Sometimes the borrowers have tried to work with the bank, find that they are unable to and that the bank will not offer them any relief. The borrowers find that they cannot afford to pay the mortgage and decide to walk away. The bank may still file suit to legally get the property back and sue the borrowers for the balance.

A number of borrowers approach the bank to modify the terms of the loan, either the amount of interest, the amount of monthly payment, the length of the mortgage or the principal balance. If the bank agrees to modify the mortgage, the borrower signs a modification to the mortgage, which is recorded of record.

Still other borrowers find that the bank has filed a lawsuit for foreclosure against them, asking for the home back and asking that the borrower pay the balance of the mortgage loan above the price received by the bank in a foreclosure sale.

What is the tax impact of these different ways of dealing with an “underwater” residence? As a general rule, if the bank cancels (“forgives”) debt, the amount of the canceled debt is normally considered income to the borrower. The bank would issue a Form 1099 to the borrower to tell the borrower how much the borrower has to report on his or her federal income tax return.

The 2007 Mortgage Forgiveness Debt Relief Act exempts a borrower from as much as $2 million in forgiven debt. There are several catches with this law. First, the debt had to be acquired before January 1, 2009, so any amount of debt incurred after that date does not qualify for the exemption. Second, the amount of debt had to have been used solely to buy, build, remodel or repair a primary residence. If the borrower took money out of the home equity to pay tuition, medical bills, vacations, cars, down payment on a second home or investment property, that debt is not eligible for exemption.

There is a chance that the homeowners could avoid the taxes if they can prove that they were insolvent at the time. Insolvency means that the total value of the debt exceeds the total assets. This is a tricky proposition, as the amount of insolvency is determined first and if the amount of the debt that is discharged is greater than that amount, there still may be taxes owed.

The bottom line is that before a homeowner takes what they think might be the only alternative, that person should check with their tax advisor to determine if there are any tax consequences to the decision.

Denice Gierach is a lawyer and owner of The Gierach Law Firm in Naperville. She is a certified public accountant and has a master’s degree in management. She may be reached at 630-756-1160.