I sure hope the Mortgage Debt Forgiveness Act (MDFA) is extended soon, so clients can relax their collective minds. It expires in 4 months. I thought it would have been extended by now.
The MDFA says that if a homeowner is foreclosed upon or short sells his or her primary residence then no tax is due on the 1099 issued afterward. For foreclosures, the mortgage amount minus the market value of the property is taxable to the owner under the 1099. For short sales, it’s the total mortgage amount minus the amount repaid in the short sale that’s taxable.
The graphic above from the Chicago Tribune shows that the AVERAGE foreclosure case in Cook County taxes 682 days. So, If you started a strategic default one year ago you have almost one more left to go. Meanwhile, the law is about the change and leave you hanging with one foot over a cliff. A big 1099 will be dropped in your lap at the end of the short sale or foreclosure and that will send many over the financial edge.
Short sales will no longer be an attractive option if the MDFA expires. It’s great to get a release of deficiency in a short sale, but if a lender is shorted $100,000 after a short sale (not unusual) the owner faces a $25,000 tax bill (at an estimated 25% tax rate). That’s rough. Unless a client can claim insolvency and thereby knock out a 1099, a short sale will make no sense in many cases.
One strategy that will become very popular if the MDFA expires is the surrender of a property in a chapter 13 bankruptcy. This is not a new method of avoiding tax on the 1099, but it will take on new importance if the MDFA expires.
If we lose the MDFA, there will be three ways to avoid tax on the 1099:
Surrender house in a chapter 13. The law allows a homeowner to file a chapter 13 bankruptcy and surrender the underwater house. This means the owner stops making payments on the house and it returns to the lender in a foreclosure. It doesn’t matter what assets or income the owner has (there are limits on the size of the mortgage). The owner does not have to pass the means test required in a chapter 7. The owner stops making payments, files the chapter 13 and stays in the home until the end of the foreclosure. The 1099 is wiped out by the chapter 13 and the owner is released from any deficiency judgment. The owner makes a few payments to the bankruptcy trustee for attorney’s fees and other costs and then is discharged from all liability including the 1099. Sweet, right? The negatives: attorney’s fees are about $3500.00 and the owner’s credit is damaged. If the client has a second mortgage, there is a chance that the second mortgage company might file a claim that the mortgage is unsecured, but that usually does not happen. Very few clients other than real estate investors needed to use this . That’s because in Illinois, there are few to no deficiency judgments on first mortgage foreclosures and the 1099s after a foreclosure were blocked by the MDFA, so there was no need to file a chapter 13 for the vast majority of primary residence foreclosures. I look for this to become a much-used strategy if the MDFA goes away.
Insolvency. A 1099 after a foreclosure is wiped out if the homeowner is insolvent, meaning that the sum of all debts is greater than the owner’s assets. I find that many clients do qualify as insolvent, which would mean they would not need to file a chapter 13. This is a simple remedy, but it’s all or nothing. You either are or are not insolvent.
Chapter 7. Filing a chapter 7 bankruptcy will knock out the 1099, but homeowners have to pass the means test which requires a relatively low income. Also, there are asset limits that have to be met. Generally, we use chapter 7s only when the owner passes these tests and has a large second mortgage or only a first mortgage and high credit card debt.
Of these three solutions, the chapter 13 surrender will be only remedy that works for many clients and should at least be considered when constructing a strategy for an underwater property.