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No Replacement for the Mortgage Debt Relief Act yet. Now what?

Ask any real estate professional who handles short sales what is their most pressing concern, and chances are they will point to the fact that as of December 31, the Mortgage Debt Relief Act of 2007 is set to expire. As of today, there is no serious replacement or extension on the table. This has many agents greatly concerned about the future of short sales, with some speculating that it may be the end of the run. I disagree wholeheartedly, and here is why:

First, let’s recap what the Mortgage Debt Relief Act of 2007 does. The Act provides for protection for some sellers regarding the tax liabilities from the 1099-C received when a lender forgives their debt. In plain English, when a lender waives deficiency, that amount is “Forgiven” debt, and a 1099-C is issued. According to IRS rules, this forgiven debt is to be considered as “income,” and therefore subject to be taxed. While wholly unfair to the seller, since this is not actually income received, it is, nonetheless, law. The Act protected those who are selling  primary residences, and usually applies only to first liens, credit lines used for purchase money or home improvement. In other words, it was a major selling point in a seller’s consideration of how to address their selling situation, and one that made a short sale attractive over a Deed in Lieu or a foreclosure.

The Fear
Many agents fear that without the protection of the Act, short sales will cease to be an attractive option for homeowners, but I believe that this is unwarranted. The main reason for this is that, at least for me, about 40% of short sales do not qualify for the protection of the Act right now, and yet; sellers still feel that the benefits outweigh the risks. Further, new GSE (Fannie/Freddie/HUD) guidelines are making full deficiency waivers more of a certainty than in the past. Moreover, it is extremely rare that sellers not protected by the Act actually owe a tax liability. Let’s take a look at these three major points in depth:

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Protected vs. Unprotected Property
As of now, even with the Act in force, only primary residences are covered. This means that a large percentage of sales are not covered. There are certainly many sellers who are liquidating investment properties and second homes. The benefits afforded to these sellers are manifold, including:

• The chance for a full deficiency waiver
• Avoidance of a foreclosure on credit
• Psychological benefit: Taking action and selling vs. letting bank foreclose

Tax Liability vs. Deficiency
It is important for agents to understand this difference, because confusion of these terms is commonplace.

Deficiency: The difference between what the lender nets on sale versus what the borrower owes. This difference will be reflected on the 1099-C issued by the lender.

Tax Liability: This is the amount that may be considered forgiven debt, and therefore, income, based on current IRS rules. This is what is currently covered in some cases under the Mortgage Debt Relief Act.
In other words, Deficiency is what you owe the bank, and Tax liability is what you owe the IRS, and the two are not mutually exclusive.

New Guidelines
As of November 1, 2012, the major Government Servicing Entities (GSE’s) such as Fannie Mae, Freddie Mac, and HUD, have amended their guidelines to include a full deficiency waiver for most sellers. This is an important development, because the deficiency waiver preserves the most valuable benefit of a short sale for the sellers. The ability to complete a short sale and be virtually guaranteed a full release on the first lien is a major step in the direction of solidifying the short sales place in the market. In most cases, a full deficiency waiver means more to a seller than tax liability protection.

Tax Liability
This section is not intended to give legal advice, and I am not an attorney. It is my position on ALL short sales, that the seller has competent legal representation. I work very closely with attorneys in the short sale process, and here are the reasons why most attorneys and CPA’s will agree with my assessment on tax liability;

On a short sale not covered under the Act, the seller’s lender will issue a 1099-C-forgiveness of debt. This can be counteracted in several ways. The most popular are:

• IRS Form 982. This is the insolvency test. In many cases, regardless of income or assets, a sellers paper debt meets or exceed their assets. In such a case, the seller may be legally insolvent, thus exempting them from tax liability. In other words, all debts, including all mortgages (which are most likely underwater) count towards liabilities. This is especially helpful for sellers with more than one property. In all cases I have seen where sellers, even showing significant assets, Once they showed their liabilities via this form, the insolvency test was passed and they were not liable for taxes owed. To find out if your seller qualifies, always refer to a competent attorney or CPA.

• Loss on Sale. This is another way that a good CPA can offset tax liability. The 1099 income will be reported, but the loss on the sale should counteract this income. The loss will include the difference between selling price and purchase price, plus any down payment the seller put into the transaction.

Conclusion
While it is my personal belief that the Act will be extended or replaced sometime in 2013, the expiration of the Act is no cause for quitting short sales. In fact, the new GSE guidelines may make short sales even more attractive to sellers. To protect yourselves and your sellers, partner up with a good attorney and CPA and let them counsel your clients as to their tax options, and take that short sale listing!

Mortgage Debt relief Act Information:

http://www.irs.gov/Individuals/The-Mortgage-Forgiveness-Debt-Relief...

Here is the original article here:

http://josephalfe.com/2012/11/no-replacement-for-the-mortgage-debt-...

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Replies to This Discussion

You are correct.  No matter what the seller does-walk away and let it foreclose, DIL, or short sale, they will get a 1099.

I agree...They say it costs $40-60,000 to complete the foreclsosure.  If a bank does cash for keys, cleanup, repairs, utilities, all that is tacked on to that difficency judgement...Better to do the short sale.

I am coming to the rescue on this one.

Senate Bill 2250 is in the Senate Finance Committee currently according to Senator Bill Nelson who sits on this committee.

 

Senator Nelson emailed me as I have been following this progress since March 2012 when the bill was submitted.

 

His latest update only 2 weeks ago said the bill is up for the Presidents signature and is to extend the Act until December 2014 when it will be reevaluated again to decide if we will need further extensions.

 

The hope of Congress is this will be signed into law before the current session breaks for Christmas.

 

 

This is fabulous news Kevin!  Thank you for sharing!  I have a number of clients who will be incredibly relieved to see this happen!

This is a very important topic.

Hopefully Congress will sign it into effect through 2014, though otherwise we need to know all the other full ramifications as clients are going to want to know the tax implications... and we are their local point of resource.

Option #3 no one is mentioning is very California-centric:

If the loan in question is a CA purchase money loan, the only recourse the lender ever had was against the property and never against the borrower.  You can't be 'forgiven' on something you never had personal liability for - so there is no forgiveness of debt.  Attaching a note from the CPA or tax preparer on your tax return, the 1099 (which will inevitably come) should be informational only and I presents a strong case for not being taken it in to income.

Of course the alternative is, report it as income even if it isn't really, because the possibility of being audited is just too scary.  :)

Hey Joe -

I read your article and it's a good read.  Quick comment:  The capital loss may be limited depending on seller's structure.  If they have a real estate business, i.e. a corporation, LLC or several of these, they may be able to take the entire loss.  If they're individuals, I believe that they are subject to the capital gains exclusions up to $500k and would similarly not have access to capital losses of commensurate amount.  BUT, I'm NOT a tax person, and my tax knowledge is NOT current!

Ern

1) The debt relief extension has made it through the Senate Finance Committee, but has Not been voted on by the full Senate or by the House which must occur-iether on its own, or part of another bill.  Of course, we hope it passes but who knows with the "financial cliff" politics.  I've always thought it would be extended.

2)  I'm sure Joseph wasn't stating as a Fact, that the debt relief act will NOT be extended..only a "what if".

3)  I'm not a CPA either, but the "capital gains exclusion" has nothing do with debt forgiveness from a loss, and     doesn't apply.

Read Joe's article.  He DOES discuss the use of capital losses.  And capital losses and capital gains ARE related in terms of tax treatment for individuals. 

This is not as troubling as it may first appear. For example, I have successfully attacked the Cancellation of Debt (COD) with the IRS. The MDFRA was one of four strong arguments on why a homeowner does not have a tax ramification on short sale forgiveness of debt. It would have been nice to extend this but it is not a priority now as there are more pressing matters. It is also possible that it is extended later and made retroactive to 1/1/13.

Paddy Deighan J.D. Ph.D

1) MDRFA

2) 982

3) no personal liability on CA 1st TD (or any CA 1st TD going towards non-judicial foreclosure.

4)  ???

Steve, there are other IRS provisions in addition to 982 that can help most home owners and there are other legal arguments that are not associated with any particular statute or code provision. 982 is not the best option but if you include that there are 5 lines of attack and they have worked

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