Over the course of the past two and one-half years, I’ve met with hundreds of folks experiencing the trauma of dealing with huge negative equity in their homes. In lay terms, they’re “underwater” – meaning that the value of their home has dropped below what they paid, and frequently is now less than what they owe. This has become a common phenomenon over the past five years. But frequently, being underwater is not the only problem. If it were, many homeowners would likely remain where they are. However, an additional circumstance, such as one of the feared 3-Ds, Death, Divorce, and Debt, is frequently an accompanying factor that has brought homeowners to my office.
This post will focus on the Scylla and Charybdis of home ownership today: Distressed housing coupled with a distressed marriage. Here are some tips, traps, caveats, and general observations that I’ve gleaned from distressed housing clients contemplating divorce:
I. GENERAL THOUGHTS
• Don’t keep looking in the rear-view mirror – you’ll drive off the road! How and why you got here is a concern that runs a distant second to where you’re now going. In most cases, the clients I’ve met who were anticipating divorce avoided the blame-game, and wanted to make the best of a difficult situation. This is a good thing; a collaborative, realistic and rational approach to a solution is much better than an adversarial one.
• Good information can be liberating. Fear thrives best when allowed to feed on misinformation. Most people are inundated with opinions, rumors, and horror stories about the foreclosure crisis. They need to separate fact from fiction before they can make informed decisions about what to do in their own personal situation. Armed with good information, I’ve seen clients make far better choices for their mutual best interests – even when they are planning to divorce.
• Demographics make a huge difference when dealing with distressed housing issues and distressed marriages. The reason is that time horizons (e.g. age), financial condition (e.g. ability to repay possible deficiency liability) employment status and opportunities, children (e.g. special needs, ages, school districts, etc), credit history, additional housing options, etc. all play into the distressed housing decisions that must be made going forward.
II. SPECIFIC ISSUES
• Does either spouse want to retain the home? This bears on what type of solution should be sought first. A loan modification is designed to keep the borrower in the home – a short sale or deed-in-lieu is not.
• How many loans encumber the family home; when were they taken out and what were they used for? This is very important when evaluating deficiency liability. Oregon has an anti-deficiency law – even for subordinate liens, but it is narrow in application.
• If the family home is to be put up for sale, who will list the property and what is the agent’s marketing plan? Picking one of the spouse’s friends may not be the best choice. Alternating agents upon expiration of a listing is not be suitable either. The rules and strategies are different when marketing distressed properties. You want an expert who has a few short sale “notches” in their belt. If not, make sure they partner up with someone who does.
• Do the spouses have a truly realistic view of what their home will sell for? Today, market value is not necessarily what anyone says it is – it is what a ready, willing and able buyer is going to actually pay. Good recent comps are really the only true indicator of value, and even then, there can be surprises.
• Do they have patience necessary in going through the ups and downs of the short sale or deed-in-lieu process? It can be laborious and frustrating. Are they up to it?
• Are the spouses jointly obligated on the home loan? This makes a big difference since a short sale or deed-in-lieu could result in lingering promissory note liability unless expressly forgiven by the bank. One spouse should not be in total control of the decision to short sell the family home, if it could expose the other spouse to significant personal liability after closing.
• If the home is “underwater” (i.e. it has negative equity), there is a potential issue of cancellation of debt income under IRC §108. Any distressed sale event, from loan modification to deed-in-lieu, short sale and foreclosure, could result in the recognition of phantom income that is taxable at ordinary income tax rates. However, if, following the divorce, one spouse will end up insolvent and the other not, the solvent one may be subject to potential deficiency liability and income tax liability.
• How long have the spouses actually lived in the family home? This is important under the gain avoidance provisions of IRC §121 (the $500,000/250,000 exemption), as well as the avoidance of income tax liability under IRC §108. To qualify, they must have resided in the home as a primary residence for two of the last five years. And remember, you can only file jointly and get the $500,000 exemption, if you were married as of December 31 of the year of sale.
Conclusion. The above list is not even close to exhaustive. Issues of credit, future housing needs, and many others, come into play when dealing with distressed housing in the context of a distressed marriage. Even though husband and wife will not remain married, a resolution will better serve them both if decisions are reached collaboratively.