Tax Consequences – The IRS treats loan workouts arrangements such as foreclosures, short sales, modifications, deeds-in-lieu, etc. as either “significant” or “not significant.” Modifications can affect the legal rights of the lender or borrower. If the modification is significant, the IRS will treat it as a taxable event. According to the Treasury Regulations, such things as a change from recourse to non-recourse debt, a change in the yield, or a change in priority (if it results in a change of the payment expectations) are generally all considered “significant.” Such things as a change in the timing of payments (under certain conditions) or substitution of security (again, under certain conditions), are generally not considered significant. The upshot of these rules is that if the modified obligation between borrower and lender is a significant change, it may result in taxable income on the amount of the debt the borrower has been relieved of.₁

However, much depends upon whether the secured debt is “recourse” on “non-recourse.” Generally, non-recourse debt is debt in which the lender’s legal right of collection upon default is limited solely to specific property, such as the property identified in the trust deed itself; the borrower’s personal assets are not subject to collection. Nonrecourse debt that is cancelled is not a taxable event. However, if the lender may pursue collection of the borrower’s personal assets beyond the foreclosure of the secured property, it is known as a “recourse” debt, and taxable. The “recourse” vs. “non-recourse” determination is based upon state, not federal, law.₂

Mortgage Forgiveness Debt Relief Act of 2007/Federal Bailout Legislation of 2008 – This federal law became effective for discharges of debt on or after January 1, 2007. It was scheduled to end January 1, 2010, but was extended through December 31, 2012 by the Federal Bailout Legislation (H.R. 1424) of October 3, 2008. Under this law, a taxpayer’s discharge of indebtedness due to restructuring of the loan, short sale, deed-in lieu, or foreclosure, of a qualified principal residence is excluded from taxable income.₃However, only cancelled debt used to buy, build or improve one’s principal residence – or refinanced debt incurred for those purposes qualifies for this exclusion. If the debt was refinanced, the exclusion applies only to the extent that the principal balance of the initial mortgage immediately before the refinancing, would have qualified. The exclusion only applies to a personal residence for which the taxpayer paid $2,000,000 or less.₄

Thus, for most distressed sales, transfers or foreclosures of a primary residence where the acquisition cost was $2,000,000 or less, there is no income tax consequence to the seller/owner for the cancelled or forgiven debt unless the transaction occurred after December 31, 2012.₅ If it is subject to tax, it will be at ordinary income tax rates.₆ Note: If the debt is not cancelled, that is, the taxpayer repays it (voluntarily or involuntarily), there would normally be no debt cancellation treatment.

Promissory Note Liability – Oregon’s trust deed law provides that upon foreclosure of a “residential trust deed” there is no right of deficiency.₇ A “residential trust deed” is defined as “…four or fewer residential units and one of the residential units is occupied as the principal residence of the grantor, the grantor’s spouse or the grantor’s minor or dependent child at the time the foreclosure is commenced.”₈ Thus, the indebtedness secured by a residential trust deed is essentially “non-recourse” in the sense that upon foreclosure the lender may not pursue any deficiency against the borrower for the shortfall between the indebtedness due and the amount recovered by the lender upon resale. In cases of non-residential trust deed foreclosures, the lender may pursue a deficiency. However, to do so the lender must judicially foreclose the trust deed (that is, filing in court rather than the traditional non-judicial trust deed foreclosure by advertisement and sale). This is not normally something that occurs in Oregon with any frequency today. So long as the trust deed is foreclosed non-judicially, that is, by advertisement and sale, there is no deficiency regardless of the use to which the property was put.

However, if there is no foreclosure of the residential trust deed, that is, the borrower and lender enter into a consensual agreement to either a short sale transaction or a deed-in-lieu transaction, the anti-deficiency issue is moot, since there is no foreclosure, judicial or otherwise. In other words, in a distressed transaction where, for example, the homeowner has negative equity (that is, the total secured indebtedness exceeds the present fair market value of the property – or in the vernacular, it is “underwater”) and the lender consents to a deed-in-lieu or short sale, the lender may also pursue the borrower for the amount of the debt that remains unpaid (assuming the issue has not already been addressed at the time of the short sale or deed-in lieu). It is for this reason that promissory note liability must be addressed with the lender before closing of the transaction. Saying nothing will not likely be construed as a waiver by the lender of its rights to pursue a deficiency. Some deeds-in-lieu contain language providing for survival of the remaining indebtedness and may even call for the borrower to execute a promissory note. (Even if they do not, it may not necessarily prevent the lender from pursuing the remaining promissory note liability.) The same holds true for short sales; that is, the lender may condition its consent to a short sale transaction upon the borrower signing a promissory note for the remaining indebtedness.

Thus, the failure to address the lingering liability under the promissory note may result in it remaining under the note, which the lender could pursue at any time during the 6-year statute of limitations. At some point in time, Lenders may simply accumulate all of the unpaid short sale or deed-in-lieu indebtedness left unresolved over the last few years, and turn it over, in bulk, to a collection company or lawyer for recovery after the credit crisis abates and borrowers get back on their feet.

Credit Scores – Everyone knows that their FICO score is probably the single-most important factor in not only obtaining a loan, but also in establishing the terms of the loan, including the interest rate. Today, one’s FICO is more important than ever. In the past, during the real estate boom, a low FICO might result in a higher interest rate on a home loan. However, today, a low FICO may actually prevent a borrower from obtaining any home loan. So the issue today is that while homes are the most affordable in decades, due to the recent collapse in the credit markets, banks are reserving their lending to only the most qualified, and their FICO score plays a much more important role in the qualification process. Each lender has its own guidelines, but generally a 720 or above is considered necessary to secure a prime home loan. This is probably at least 100 points higher than during the heydays of 2005 – 2007.

So when distressed buyers are contemplating alternative methods of either restructuring their home loan through modification or refinancing, or doing a short sale or deed-in-lieu, or are contemplating foreclosure or bankruptcy, the FICO impact is an important factor in the decision-making process. Here is a summary of the ramifications, with the caveat, that these are ranges only, as much depends on a borrower’s employment, their financial records, and their credit history (e.g. do they pay their bills on time?).

On the website, myfico.com, there is a chart showing just how much money can be saved on a home loan, depending on current interest rates (as of September 20, 2009) that are driven by one’s FICO score. On a $300,000, 30-year fixed rate loan, the figures vary from a 4.732% rate annual rate and a monthly payment of $1,562 for a FICO score of between 760 and 850, versus a 6.321% rate and a monthly payment of $1,861 for a score of between 620 and 639. The monthly difference is $299.00, or nearly $3,600 per year.

Here are two of the frequently asked questions appearing on the myfico.com website:₉

Question: How does a foreclosure or short sale affect my credit score?

Answer: Credit bureau reports are limited in how they represent foreclosures today, so it’s generally not possible to tell from the credit report if a reported foreclosure is a short sale, deed in lieu of foreclosure, settled account, regular foreclosure, or some other variation. The FICO® score treats all of these descriptions that appear on credit reports as serious delinquencies, so they have an impact on the score similar to the impact from a charge off, tax lien or account included in bankruptcy. (Italics added.)

Question: How long will a foreclosure affect my FICO score?

Answer: A foreclosure remains on your credit report for 7 years, but its impact to your FICO® score will lessen over time. While a foreclosure is considered a very negative event by your FICO score, it’s a common misconception that it will ruin your score for a very long time. In fact, if you keep all of your other credit obligations in good standing, your FICO score can begin to rebound in as little as 2 years. The important thing to keep in mind is that a foreclosure is a single negative item, and if you keep this item isolated, it will be much less damaging to your FICO score than if you had a foreclosure in addition to defaulting on other credit obligations.₁₀

Unfortunately, FICO’s formulas are proprietary and closely guarded, so one can only speculate, based upon a certain amount of logic and anecdotal reports from people who have actually monitored their FICO after engaging in some form of distressed sale or other transaction. Here are some factors that must be taken into consideration when estimating the impact of the resolution of a mortgage debt on one’s credit:

• What was the seller’s credit history like before the distressed resolution? There is some thought that an otherwise good credit history – especially one where there are no late payments – is still quite important.
• Will the owner continue to make timely payments to other creditors? If so, it will help resuscitate the rating faster than having other charge-offs.
• Is the debt resolution an actual nonpayment (i.e. causing a write-off) or is it simply a modification of the loan terms, such as repaying the debt over an extended term? This would likely be treated differently than a charge-off.
• How is the transaction being reported to the rating bureaus? It’s one thing to report the debt as not paid and written off, versus paid, but not in accordance with the original loan terms. This may be an issue borrowers may want to discuss with their lenders, especially in a short sale where the remaining debt is being paid off over an extended term.
• It would seem apparent that cooperation with the lender would help in determining how the situation is reported to the credit bureaus. For example, a foreclosure, where the buyer remains in the home throughout the entire process (or moves out but rents it to a third party) and does not pay the rent, will likely be more harshly reported than a short sale. One reason is that in the first instance, the lender is getting nothing back but the property and a bad debt. This means taking the home into their already bloated REO department and having to expend significant funds to clean it up and remarket it. In the second instance, the lender is free of the property, the bank’s capital account is not as negatively affected, and it has no continuing maintenance and property tax obligations for the property. If the loan shortfall is being repaid by the former borrower, it is even better.
• The MHA Foreclosure Alternative program for short sales (HAFA – discussed above) has proposed that sellers successfully completing a short sale will be eligible for home financing under Fannie and Freddie after not more than two years, assuming his/her credit is otherwise comparable to what it was before the short sale.

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Footnotes

1. Note that debts cancelled due to bankruptcy and insolvency (i.e. liabilities exceed assets) are not taxable.
2. The above is a generalized summary only and for specific answers, a CPA, tax lawyer, or other expert should be consulted.
3. Note: Oregon state tax law does not follow this approach – that is, it may be taxable.
4. $1,000,000 if married and filing singly.
5. Note: The non-taxable portion of the cancelled debt reduces the tax basis of the residence, so there still may be a capital gain consequence upon the sale. So, even in distressed sale situations, the taxpayer should look to the gain exclusion provisions of Section 121 ($250,000 single filer/$500,000 married filing jointly), assuming the residence was occupied as a principal residence for two of the last five years.
6. Note: There is no income tax consequence if the taxpayer is insolvent or files bankruptcy.
7. ORS 86.770
8. ORS 86.705(3) Note that under this definition, if the homeowner abandons the property, or if the homeowner moves out before the foreclosure commences and rents it out, there is a risk that the lender could pursue a judicial foreclosure and secure a deficiency judgment.
9. http://search.myfico.com/promosearch.cgi?sp_a=sp100399e3&sp_p=all&sp_q=short+sales&Search x=12&Search.y=8
10. Note: Since this article was written, Fannie Mae has published materials indicating that it will purchase loans from banks even though borrowers have a distressed transaction in their past. For a borrower with otherwise good credit and 20% down, Fannie has said the waiting period would be two years for shorts sales; two years for deeds in lieu of foreclosure; and five years for standard foreclosures. Given this willingness to permit formerly distressed borrowers back into the residential credit market, it is quite possible that even these standards will be relaxed over the next year or so, as distressed transactions continue to work their way through the system.