Foreclosure Epidemic Likely Means Additional Tax Liability

The recent national surge in home foreclosures coming on the heels of the collapse of the sub-prime lending industry and decline in home values likely means additional bad news for those former homeowners who feel like they just lost everything: additional income tax liability.

Income tax liability? From losing your home? Such is the nature of the United States Internal Revenue Code.

Given the foreclosure epidemic and the huge losses to which lenders of all sizes are now exposed, many lenders are willing to enter into a variety of work-out programs with their borrowers to avoid foreclosure. Avoiding foreclosure does not necessarily mean keeping the home, however.

The foreclosure process is time-consuming for the lenders and often subjects them to the additional time and expense of physically evicting the former home owner from the home after the foreclosure sale. From the borrower's perspective, a foreclosure is a huge blow to credit worthiness and will impact the borrower's ability to finance major purchases for years to come.

Considering many lenders' goals of reducing their losses on foreclosures, borrowers have met with success recently in negotiating "short sales" with their lenders. A short sale is the borrower's reconveyance of the home to the lender for less than the amount owed on the mortgage.

For example: Joe obtained a creative home loan and purchased a home at the height of home values and during the most liberal period in sub-prime lending.

Eventually, the appraised value of Joe's home began to drop and the "creative" part of his home loan kicked-in. Perhaps his interest rate adjusted or his interest-only payments ceased and he was required to commence paying both principal and interest.

In any event, Joe finds that he cannot afford to continue making the mortgage payments and, due to market circumstances, he now owes more on the mortgage than the home is worth. In other words, he is upside down in the home.

Joe defaults on the mortgage payments and is now subject to the foreclosure process.

Applied to the example above, the borrower might successfully negotiate a short sale with his lender. Many lenders are now accepting a reconveyance of the home and forgiving the remaining debt exceeding the value of the home.

In the example, Joe may have purchased the home for $300,000. He has made interest-only payments on the loan for a year, but due to the recent slump in the market, the home is now worth only $250,000. He still owes $300,000 on the mortgage. The lender, therefore, may accept a reconveyance of the home - in essence a $250,000 payment - against the $300,000 debt.

The sale is "short" because the value of the home does not cover the amount of the mortgage. The lender may forgive the additional $50,000 owed by the borrower in order to avoid the foreclosure process, or to avoid litigation expenses in pursuing the borrower for the deficiency balance, and essentially cut its losses.

For the borrower, he avoids foreclosure and its ramifications to his credit, as well as facing a likely judgment for the amount still owed on the debt.

The hidden drawback here, though, is that the tax code treats Joe's debt relief as income. By being relieved of the obligation to pay $50,000, the IRS considers that Joe has in effect put $50,000 in his pocket.

The debt relief is subject to ordinary income tax. Joe may not even know of his additional tax liability until he receives an envelope in the mail from the lender containing a 1099 form reporting the debt relief income to the IRS.

The same result may follow if Joe simply walks away from the home, allows foreclosure to proceed, and then the lender elects not to pursue Joe for collection of the deficiency balance on the loan.

The ripple effect of the sub-prime lending market over the past couple of years has yet to reach its full effect. Individual homeowners must be wary of all consequences of divesting themselves of the homes they purchased in that market.

While financial planning might be the last thing on a borrower's mind when he or she faces the harsh reality that the home will be lost in some way, the unforeseen consequences of a foreclosure or short sale can only be addressed through the sound advice of a tax professional, CPA, or, at the very least, the IRS website.

Of interest to us lawyers, however, is the approach the IRS will take to the likely spate of litigation that will proceed, alleging that these borrowers, now facing additional income tax liability through the loss of their homes, should not be responsible for the 1099 income tax burden, by virtue of alleged fraud or misrepresentation on the part of the sub-prime lenders.

As they say, "the Wheels of Justice grind slowly." We will all have to wait to see how this shakes out.