On December 20, 2007, H.R.3648 Mortgage Forgiveness Debt Relief Act was signed into law to relieve distressed homeowners from having to pay taxes on the amount of debt that was forgiven in a refinance or loan modification, short sale, or foreclosure.
The 2007 Mortgage Forgiveness Debt Relief Act was set to expire on December 31st 2012 but was extended yesterday through December 31, 2013.
Watch John and Anthony explain why the Mortgage Relief Act on FOX25 Morning News
Click image below to watch video. (new window will open)
Who Does The Mortgage Debt Relief Act Affect?
This Law Affects All Homeowners Who:
- Are granted principal forgiveness on their loan
- Do a short sale on their home
- Do a deed-in-lieu of foreclosure on their home
- Are in the process of foreclosure or have lost their home to foreclosure
Why Is It Important Now?
First of all, there will be many more short sales this year than in years past, meaning more borrowers will need the debt forgiveness now. Borrowers who get approved for permanent modifications often still can’t afford the payments, which is why so many homes fall into foreclosure after a loan modification. And now banks are starting to look to short sales when loan modifications fail rather than foreclosures. Federal Housing Finance Agency (FHFA), announced it was directing Fannie Mae and Freddie Mac to “develop enhanced and aligned strategies for facilitating short sales, deeds-in-lieu and deeds-for-lease in order to help more homeowners avoid foreclosure.”
And as we reported earlier this month, the current housing market has a huge negative equity gap—$3.7 trillion—meaning more homeowners owe more on their homes than they are worth. In an online presentation this week, RealtyTrac vice president Charles Engel suggested, “Even if these homeowners aren’t struggling to make mortgage payments and therefore are at low risk for foreclosure, if they need to sell sometime in the next five years it’s likely they’ll need to sell via short sale.”
We Need This Act More Than Ever
As of today you only have 12 months left before this Act expires, which may seem like a long time but short sales can take on average 4 to 6 months to complete, and that’s only with the most experienced short sale team. A loan modification can take up to 3 months to approve for the trial modification, but getting approved for a permanent loan modification takes much longer. A deed-in-lieu of foreclosure can take at least 3 months. If you are in the process of foreclosure it could take 6 months to 1 year before it’s completed. Principal forgiveness timelines will vary, but on average they take at least 3 months, like any other modification. So it’s important that we now have this extension in place for distressed homeowners who will need it.
On Monday, February 13th, President Obama released his budget proposal for 2013 where he called for an extension of this Act.
The proposal states that although ”there has been improvement in the residential real estate market, there is still an elevated number of cases in which homeowners may have discharge of indebtedness income with respect to their home mortgage loans.” And since the ways to avoid foreclosure often involve some forgiveness of debt, it was necessary for the expiration of this Act to be extended.
There are four main areas that this Act affects: principal forgiveness, foreclosure, deeds-in-lieu, and short sales.
This method of modifying loans is becoming more and more popular and with all the talk about principal forgiveness related to Attorney General Settlements, one important aspect is flying under the radar: the taxes that would be owed if this Act was not in place.
For example, if a borrower receives a principal reduction of $100,000, it will more than likely put them in a position to be able to afford their home and keep it long term. If this Act expires, this borrower would owe around $30,000 in taxes at the end of that year, if they were taxed at the average rate. No one who is having trouble affording their home can afford to pay that much in taxes.
President Bush put it best the day he signed this Act into law:
“The bill I sign today will help this effort by ensuring that refinancing a mortgage does not result in a higher tax bill. Under current law, if the value of your house declines and your bank or lender forgives a portion of your mortgage, the tax code treats the amount forgiven as money that can be taxed. And of course, this makes a difficult situation even worse. When you’re worried about making your payments, higher taxes are the last thing you need to worry about. So this bill will create a three-year window for homeowners to refinance their mortgage and pay no taxes on any debt forgiveness that they receive. And it’s a really good piece of legislation. The provision will increase the incentive for borrowers and lenders to work together to refinance loans — and it will allow American families to secure lower mortgage payments without facing higher taxes.”
After a home is foreclosed on often the debt is forgiven because the bank realizes that recovery efforts on the deficiency balance would be unsuccessful (the deficiency balance is the amount of the mortgage less the amount that the bank receives after it re-sells the property).
For example, let’s say a homeowner has a mortgage for $500,000 then the home is foreclosed on and resold for $350,000. The cost to foreclose and resell would likely be at least $50,000. Therefore the deficiency balance ends up being about $200,000. If this $200,000 was treated as income and taxed at an average rate of say 30%, this family would owe $60,000 in Federal Income taxes!
Obviously a family that suffers through the financial and emotional devastation of losing their home to foreclosure does not have $60,000 to pay in taxes. This is why the 2007 Mortgage Relief Act is so important to those who have been foreclosed on.
A deed in lieu of foreclosure is like opting for a “voluntary foreclosure,” since you are essentially handing over the property to the bank without having to go through the actual foreclosure process. Like many foreclosure alternatives, there is a long list of requirements that prevents many people from qualifying for a deed in lieu of foreclosure. For example, other liens and second mortgages may limit this option, and a true hardship must exist. Since the bank is not in the business of owning properties they will only consider this option if the loan is in default and they truly believe they will have to foreclose if they do not agree to it. Lenders prefer short sales over a deed in lieu because with a short sale they don’t have to take over the property. Even under the Treasury’s HAFA program you are required to first attempt a short sale, and if that fails after 120 days then you can apply for a deed in lieu of foreclosure.
The main issue with a deed in lieu of foreclosure is whether the lender is willing to forgive the deficiency balance. If the deficiency balance is forgiven, this amount is considered a part of your “income” to the IRS. The Mortgage Forgiveness Debt Relief Act applies to deeds-in-lieu, and you have to notify the IRS that you qualify for an exception to paying tax on this income. As in the foreclosure example above, Debt Relief is essential for people who choose this option.
In addition to those who have been foreclosed on, the 2007 Mortgage Forgiveness Debt Relief Act is also vitally important to those who conduct a short sale on their home in order to avoid foreclosure. A short sale is when a lien holder allows a home to be sold for less than what is owed on the mortgage. It is the most responsible way to avoid foreclosure. They are becoming a much more popular and attractive alternative to foreclosure. Short sales typically have a smaller impact on a borrower’s credit and they allow a borrower to buy a home again sooner than if they were foreclosed on.
Short sales do not usually have as large of a deficiency balance as a loan that went through foreclosure because short sales sell for about 25% more than foreclosures on average. The biggest reason they sell for more is the properties are maintained and transferred from homeowner to homeowner, instead of homeowner to bank to homeowner (or investor).
To use the same example as above with a mortgage of $500,000, let’s say the property sells for $400,000 and after all closing costs the bank nets $360,000. In almost all short sales the bank waives the deficiency balance, which in this case would be $140,000. If this was taxed at an average income tax of 30% this family that went through a short sale would owe $42,000.
Obviously a family who sells their home through a short sale because they cannot afford their mortgage payment cannot afford to pay $42,000 in income taxes. This is why the 2007 Mortgage Debt Relief Act is so important to those who have sold their home through a short sale.
If This Act Had Not Been Extended Three Things Would Happen:
1. The US Government will NOT collect any more in income taxes because the money is simply not there. When someone in this position does not have the money to pay the taxes their accountant would write a letter to the IRS citing insolvency, proving there are no assets to pay with. In most cases the IRS would understand this and would not expect the taxpayer to pay. We have seen many people do this after conducting a short sale on an investment property and the same would take place on primary residences.
The Act does not currently apply to investment properties but very few investors actually have to pay the taxes because most do not have the money. This is why this Act should not only be extended but amended to also include investment properties which would give investors more of an incentive to pursue a short sale instead of walk away and allow their properties to be foreclosed on.
2. More homeowners will allow their homes to be foreclosed on instead of conducting a short sale because of the uncertainty of having to pay the taxes. The reason more homes will be left to go into foreclosure is because of what we call the unknown factor. Over 50% of those looking to do a short sale would not do it if they did not know for sure that they would not owe any Federal taxes. The 2007 Mortgage Relief created a much needed certainty for all distressed homeowners.
3. Less homeowners or conceivably no homeowners would entertain a refinancing plan that includes principal reduction. No borrower will ever refinance if it results in a tax consequences which will contribute to more foreclosures. Every principal reduction refinance candidate is struggling to pay their mortgage, so without the incentive of the Mortgage Relief Act they will simply give up.
The foreclosure crisis is bad enough. No matter what is done to correct housing we are looking at another five years at the least before the entire shadow inventory is worked through. Which is why we are pleased Congress signed the extension of the Mortgage Debt Forgiveness Act through December 31, 2013.Do You Qualify?
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