Tax Consequences of a Foreclosure

If all your efforts fail and your home is foreclosed, you may wonder whether there is an IRS tax bill lurking in the aftermath waiting to add more misery to a series of unfortunate events. The answer is somewhere between yes and no depending on whether the foreclosed home was your primary residence or not.

Foreclosure on a Primary Residence

The Mortgage Forgiveness Debt Relief Act of 2007 provides a tax break on discharged mortgage debt related to a foreclosure on a primary residence. Additionally, debt forgiven through mortgage restructuring, or in other words a loan modification, also qualifies for this relief. But there are some restrictions:

1. There is a $2 million limit, or $1 million for a married person filing a separate return, on the forgiven debt.
2. The tax break only applies to mortgage debt discharged by a lender in 2007, 2008 or 2009.
3. The loan must have been used to buy or build a primary residence.

Foreclosure on a Vacation, Rental or Second Home

A homeowner is still responsible for taxes as usual if the debt forgiven is on a non-primary residence. This means that the forgiven debt is treated as regular income on a cancellation of debt.

Cancellation of Debt as Income Explained

When you borrow money and the lender later cancels or forgives the debt you will likely have to report the cancelled debt amount as income to the IRS for tax purposes. The reason why the debt once cancelled is then considered income is that the money received through what was originally a loan is no longer scheduled to be repaid, though the “borrower” is still that much “richer” from the money received, which in other words is income gained. The lender is usually required to report the amount of the cancelled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.

There are some exceptions to taxable cancellation of debt income in addition to income exempted under the Mortgage Forgiveness Debt Relief Act of 2007.

1. Bankruptcy - Debts discharged through bankruptcy are not considered taxable income.
2. Insolvency - Defined as when your total debts are more than the fair market value of your total assets, which can be complex to determine and requires the assistance of a tax professional.
3. Non-Recourse Loans – In this case, a lender cannot pursue you personally in case of default and their only remedy is to repossess the property financed or used as collateral. Certain Farm Debts - The rules for this exception applicable to farmers are complex and require the assistance of a tax professional.

Bankruptcy Not Always the Best for Avoiding Foreclosure

For homeowners who have found themselves struggling to keep up with their mortgage payments after an increase in their rate or a change in their personal finances, trying to negotiate changes or modify a home loan is a better option in avoiding foreclosure than filing bankruptcy. Bankruptcy typically is a solution to an unmanageable financial burden when it consists of other debts in addition to your mortgage, like credit card and medical bills.

Bankruptcy judges are able to reduce and eliminate certain debts, but a first mortgage on a primary residence (a home that is occupied by the owner) is not one of them. A judge can not alter the total amount owed, the interest rate or any other term on these home loans. Alternatively though, a bankruptcy judge can reclassify second and third mortgages as unsecured debt which decreases their priority in being repaid, but unfortunately the weight of a mortgage burden is usually due to the first mortgage on a property.

Bankruptcy is a better prospect for homeowners struggling with a mortgage on a rental or investment property, in which case a bankruptcy judge does have the power to enforce a modification.

Regardless of the type of ownership on a property, if the homeowner is facing foreclosure, the only real tangible benefit to filing for bankruptcy that applies across the board is that it will postpone the foreclosure proceeding by at most a couple of months, only providing some temporary relief. There is also some anecdotal evidence that filing for bankruptcy can put a mortgage lender in a position that prevents them from allowing or being inclined to modifying a home loan. With the federal government’s insistence on lenders to negotiate new manageable terms on home loans, pursuing a loan modification should be the better path to preventing foreclosure.

For homeowners who feel that bankruptcy is an option for them, the American Bar Association provides more details for you to consider when making the decision. After reviewing this information (http://www.americanbar.org/groups/public_education/resources/law_issues_for_consumers/bankruptcypros.html) the next logical step is to consult with an attorney.

How to Avoid Foreclosure with a Loan Modification

A loan modification can help a homeowner permanently change one or more of the terms on the mortgage, including lowering the interest rate, increasing the term of the loan or adding missed payments to the loan balance, to make monthly payments more manageable.

5 Tips for a Successful Loan Modification

1. Keep notes of all your contact with the lender including details such as the date and time of contact, the form of contact made (in-person, by phone, fax, email, or mail), the first and last name of the representative, and the outcome.
2. Follow up any oral requests you make with a letter to the lender. Send your letter by certified mail with a “return receipt requested.” Keep copies of all letters and enclosures.
3. Meet all deadlines set by the lender, and if possible complete any requests ahead of time and as soon as possible.
4. Loan modifications are usually only available on owner occupied properties, so do not move out or rent your home during the process. Renting a home should only be considered if the rental income is enough to maintain the loan current.
5. Maintain persistent contact with your lender. Follow-up is crucial to your success. 

Call Your Lender

Prepare for your first call with the lender or loan servicer by gathering the following information and jotting down responses to these questions on paper so that you have a well prepared argument:

1. Your home loan account number.
2. Your most recent income documentation, including:
   
   • pay stubs, or if you are self-employed, your tax returns or a year-to-date Profit & Loss Statement
   • benefit statements from Social Security, Disability, Unemployment, Retirement, or Public Assistance
3. A comprehensive list of all household expenses.
4. A brief explanation of your circumstances. Illustrate for the lender the events that led you to miss your mortgage payment(s). Support your explanation with any documents you may have.
5. Describe how you have tried to resolve the problem.
6. Is your problem temporary, long-term, or permanent? How would a loan modification help you get back on track?
7. Are there any other financial issues that may prevent you from getting back on track with your mortgage?
8. What type of arrangement or work-out plan would allow you to better manage your finances?

There is no alternative to calling your lender if you are trying to successfully accomplish a loan modification. If you reach a department other than loss mitigation, ask to be transferred after taking note of the direct number.

Remember to document the date and time of contact, the first and last name of the representative, and the outcome of the call after you are done. Explain your situation and the cause of your financial hardship; i.e. interest rate increase, loss of a job, etc. You should add that you are or may soon become delinquent on your mortgage and would like to request a loan modification to avoid falling further behind and possibly facing foreclosure. Stress the urgency and seriousness of your situation.

Answer honestly any of the representative’s questions and be sincere about the disparity of your financial situation. If the representative can determine from the initial phone call that you potentially qualify, you will receive a loan modification packet that will help establish your inability to make the current or increased mortgage payment after a rate adjustment. You also must prove that a loan modification will improve your situation to a point where you will be an acceptable risk for them.

Detailed Notes are Critical

You will have to make a lot of phone calls and deal with several different people within the loss mitigation department. This in itself can lead to unique challenges and road blocks if you don’t have your efforts well documented. Keeping track with a detailed call log that reference promises, comments and details should help you overcome objections as you talk to other people in the department. If there are any delays with the loan modification and the home goes into foreclosure, the log that you have created can be used to justify your good faith efforts in trying to find a resolution to your situation. If your situation gets to a point where you lose your home to foreclosure because your bank acted in bad faith, a foreclosure attorney can use the log to build a case against the bank.

Options when Facing Foreclosure

The options that can help you save your home are time sensitive. We can't stress that enough.

The best option for you depends on your specific situation. For example, a repayment plan may be a fit for someone with only one missed payment, whereas a loan modification may be necessary for a homeowner facing a long-term reduction in income. A homeowner should contact their lender or a legitimate counselor as soon as they realize that there might be a problem in making their mortgage payments on time to determine the best solution. If you feel that your foreclosure relief situation has been mishandled or that your original loan was predatory, then make certain to contact an attorney who can appropriately review your case.

The range of options for a homeowner who has fallen behind on their mortgage payments includes:

1. Lender Payment Plans
   
   • Repayment plans
   • Forbearance - postponement of regular payments
2. Loan for Arrears Amount
   
   • This is available to homeowners who have their mortgage insured by either the Federal Housing Administration or a private mortgage insurer and is known as a Mortgage Insurance Advance Claim Payment. A one-time payment to the lender is made by the mortgage insurer to cover all or a portion of the default.
3. Loan Modification
   
   • Lenders will consider this option when a homeowner faces a permanent or long term reduction in income. A loan modification can help a homeowner permanently change one or more of the terms on the mortgage to make the monthly payments more manageable.
4. Refinancing
   
   • HOPE for Homeowners
5. Sale of the Property
   
   • With a realtor
   • For Sale By Owner (FSBO)
6. Investor Sale
   
   • Pre-Foreclosure Sale or Short Payoff: Lenders will consider accepting less than the full amount owed on a property through one of these sale options.
   • Assumption of Mortgage: Regardless of what the original loan documents state, a lender may allow a qualified buyer to assume your mortgage, especially if the current market value of the property is less than the mortgage balance.
7. Bankruptcy
8. Foreclosure
9. Deed in Lieu of Foreclosure
   
   • A homeowner may voluntarily transfer title to the property to the lender in exchange for cancellation of the remaining debt. Some states though allow lenders to pursue a deficiency judgment making the homeowner personally responsible for any remaining balance after a foreclosure sale. A deed in lieu of foreclosure is less damaging to a homeowner's credit than a foreclosure, though it does not always eliminate the potential income tax liability on the amount of debt forgiven.
10. Do Nothing

How to Delay Foreclosure, Short-Term Legal Tactics

Attempting to delay a foreclosure doesn’t mean you delay taking action. You must act with urgency in order to get the most from each of these maneuvers. The following list presents short-term solutions in anticipation of finding a permanent or more long-term result.

1. Call your Lender: You should contact your lender as soon as you realize that you will have challenges in paying your mortgage. A lender will be able to discuss all available options to prevent foreclosure and it will also relieve some of the pressure for them to aggressively push the foreclosure proceedings forward.
2. Pursue a Forbearance: A forbearance will allow you to postpone payments and catch up on back payments by paying down what’s owed over several months. This could give you time to attempt to sell your home or explore other options.
3. Negotiate a Loan Modification: You may be able to convince the bank to modify the terms of your home loan if you can demonstrate that you have the ability to make a lower monthly payment. The bank can add your missed payments to your balance, lower your interest rate, extend the term (amount of time given to repay the entire loan) of the loan, or possibly forgive a portion of the amount owed.
4. Challenge the Lender in Court: Since California is a non-judicial foreclosure state, meaning that foreclosure occurs outside of the courts, in order to delay a foreclosure via the legal system you will have to file a suit against your lender. It is recommended that you consult an attorney if you want to explore this option. One thing to start considering is that California state regulations governing foreclosures are very specific. If a bank or lender fails to follow these rules and associated timelines, it might be possible to bring suit against your lender, and it could compel the court to give you more time. It is recommended that you review California's foreclosure laws and Federal real estate, housing and finance laws to reveal any abuse by your lender.
5. Bankruptcy: Filing for bankruptcy will grant you a stay, which essentially freezes all bills due including your mortgage. This requires that you hire an attorney and can be costly, and is not always a long-term solution as advertised by many less-than-ethical attorneys. If bankruptcy does seem to be the right solution for you, and you are married with a spouse as co-owner of the property, consider filing bankruptcy individually with you first and your spouse later, stretching out the period of time that a stay is effective.

Beware of Foreclosure Rescue Scams

The unfortunate financial environment that much of the state of California is facing with regards to foreclosures has been a breeding ground for scam artists and less than legitimate foreclosure rescue companies. The stress and desperation of homeowners who are dealing with foreclosure makes it easy for fraudsters to claim to be able to help. It is strongly recommended that you research any business with the California Department of Real Estate or the State Bar of California before engaging them to help you prevent a foreclosure. You can also search for a foreclosure attorney through a legitimate attorney referral service.

The following are a few of the most prevalent scenarios in which fraud may be perpetrated.

How to Spot a Foreclosure Scam

Fraudulent foreclosure rescue firms use a variety of tactics to target distressed homeowners, from sending letters to more general approaches such as posting ads in newspapers or posters around town. It is often difficult to weed out these firms because they use the same marketing messages as legitimate companies. Once you are on the phone with them, their legitimate sounding promises offering relief sound like the magic pill you’ve been waiting for.

The first indication that you may be dealing with a scammer is that you are required to pay a hefty up-front fee, in the range of a thousand or several thousand dollars. This is sometimes compounded by their insistence that you pay your mortgage payments to them while they negotiate with the lender, but in reality keeping all the money before disappearing.

A second tactic is having the scam artist present you with a rescue loan or some other sort of rescue option where you are required to sign documents transferring the title of your house to them. As a common precaution with any documents that you sign, read the print carefully and don’t sign anything that you do not feel comfortable with. There are several schemes were the homeowner is asked to transfer the title, legally giving up ownership of the property. This type of scam can easily lend itself to a bait and switch type scenario, where certain promises are made upfront but never met after the scam artist has legal title to your home.

Another technique involves the illegitimate foreclosure rescue company filing bankruptcy for the homeowner, sometimes without their knowledge, which places a temporary freeze on the foreclosure but without any intention of following through with the bankruptcy proceedings. Bankruptcy is a very involved process that requires legal advice and can become very expensive. In most cases, bankruptcy is not the best option to prevent foreclosure, and in these cases where it is initiated by a scam artist it will most definitely end with devastating results.

How to Avoid Untrustworthy Companies

If you are having challenges or anticipate having trouble with your mortgage payments, contact your lender immediately. Alternatively, you can have a counselor work on your behalf to negotiate a loan modification plan which would offer legitimate long-term relief. Be cautious of unsolicited offers to help by mail or phone, and properly research any company before committing to their foreclosure prevention assistance.

Report Fraud

If you think you’ve been a victim of foreclosure fraud, contact the Federal Trade Commission or the California State Attorney General.

Homeowner Rights when Facing Collections and Foreclosure

For those that have already fallen behind on their mortgage and are in the pre-foreclosure stage, you are probably already receiving consistent phone calls from the bank. There are several restrictions placed on creditors and banks on how and when they attempt to collect money that is owed. This provides some “fairness” in how the bank or lender treats its communications with you. A homeowner should pay close attention to a California’s foreclosure laws to make sure that the bank is not acting overly aggressive in pursuing the foreclosure. By law banks are required to follow rules regarding time frames at each stage of the foreclosure process.

 

Restrictions on Collections Activities

It is important for homeowners to understand that they are protected by the law whenever they are facing any type of collection activity, including late or back payments on their mortgage. The two federal laws that pertain to these situations are the Fair Debt Collection Practices Act and the Fair Credit Reporting Act. All agents and representatives must comply with these laws which prohibit any unusual, abusive or misleading practices such as:

1. Attempting to contact the borrower (homeowner) at unusual times or places
2. Using threatening or abusive language
3. Harassment
4. Discussing your debt or obligation with a third party
5. Using a third party or a false identity to contact you

 

Have you been Given Enough Time and Notice?

Foreclosure laws affecting homeowner rights vary by state. It is fundamentally important that you understand what specific laws and rights are available in California: http://preventingforeclosure.org/foreclosure-rights/. Start by reviewing the basic foreclosure timeline (http://preventingforeclosure.org/help-stop-foreclosure/california-foreclosure-basics/) and make sure to understand the foreclosure process.

Some of the most important points for a homeowner in foreclosure to research are:

1. Redemption Period: Does your state/area have one, and how long is it? A redemption period is the amount of time that a homeowner has to purchase (redeem) their property back after being sold at public auction.
2. Eviction after the Auction or Sale: How much time do you have to move out after the home is sold or auctioned?
3. Bank/Lender Notice of Foreclosure: Did the bank/lender give you enough notice and did they notify you in the right manner? If a bank does not follow your state’s foreclosure procedures according to the law and regulations, you may be able to file a suit in court to give yourself more time. Period for Reinstatement: How much time before the sale or auction do you have to catch up on your late mortgage payments?