Last year, I did a lot of phone consultations with clients about their underwater homes and condos.  About 80% of those I talk with have already decided to strategically default. They could continue to pay the mortgage, but choose not to,  because the property is $80k to $100k underwater.  Usually, they are   completely  freaked out that the lender will immediately seize their assets or garnish their wages.  Fear of the mythic deficiency judgment is deep and wide.

The reality of it is that deficiency judgments in Illinois are almost nonexistent, the lender will not take any of your assets ( unless you have a second mortgage), and frequently you will be paid the leave the property in a cash for keys arrangement at the end of the foreclosure.

Foreclosure is terribly confusing  and clients have a lot of questions through the process,  so I began offering to monitor the foreclosures of clients who wanted explanation and guidance through the case. I charge a fee of $50 per month billed to the client’s credit card. At the start of every month, I check the case status and email the client. If the client wants me to review court documents, I do that too. The client can cancel at any time.  This has worked out pretty well and it seems to ease the anxiety of those going through foreclosure.

Monitoring is most popular with clients who are trying to stay in the property until the end of the case. In Cook County, most lenders are waiting about 6 months from the first missed mortgage payment to file a foreclosure. After the case if filed,  the actual foreclosure case takes about  12 to 14 months, so it’s a long process.   Those that move out of the property early in the foreclosure process usually are not interested in having the case monitored.

In Cook County, the  status of court cases is listed on the clerk’s website under “Chancery.” You just type in your name and the case status pops up. But it’s hard to interpret what’s going on in the case, so the raw data is of little use to most people. Lake County has no usable website and the other collar counties have sketchy websites  at best.

When the foreclosure is close to the end, the sheriff’s sale is scheduled. The problem is that the court websites don’t give any information on the sheriff’s sale. There are two mega-foreclosure law firms in Illinois that handle most of the foreclosures. Both of them are pretty responsive and will answer questions and will respond to calls or emails. One has a site that gives great, up- to-date information on the sheriff’s sale, but the other large firm has no website with sheriff’s sale information. Copies of motions and other court documents are always mailed to the homeowner in all foreclosures cases, so there is no lack of communication.  It’s figuring out what the motion or hearing means that’s important.

Many clients think that if they miss one mortgage payment, the bank will immediately come by, change the locks and repossess their home. Nothing could be further from the truth.

Foreclosures take more than 1 year in Illinois. During that time, the owner, not the bank,  is entitled to possession of the property.  Near the end of the foreclosure, the sheriff’s sale is held, at which the bank becomes the new owner of a house in a foreclosure. The sheriff’s sale  is about 1 year after the foreclosure is filed.  The bank finally gets “possession”  of the house about 60 days after the sheriff’s sale.

Even after the bank gets an order of possession, the bank has to file the order with the sheriff’s office for a physical eviction. That will take anywhere from  3 weeks to 2 months depending on the time of the year.  In Cook County, physical evictions are halted around the holidays and are also stopped if the temperature drops below 15 degrees. So if you are a foreclosing bank all I can say is good luck evicting someone between December and February, because it will take forever.

“Cash-for-keys”  is a humane alternative to physical eviction after a foreclosure that has become fairly routine.  The foreclosing bank pays the owner to leave the property by a certain date, thus ending all the drama, worry and delay inherent in changes of possession after a foreclosure.

So how does one work out a cash-for-keys arrangement?

1. Contact the real estate agent for the bank after the sheriff’s sale. After the sheriff’s sale, the attorney for the bank usually will know the name of the real estate agent who is handling the resale of the property for the bank. Contact that agent and say you would be interested in receiving “relocation assistance” which is the formal legal buzzword for cash-for-keys.  Generally, the agent will check with the bank and will call back with an offer.

2. How much will I get? The payment varies but it’s usually between $1000 to $2000. Some agreements pay you less the longer you stay in the property. Most agreements pay a a flat fee to leave by a certain date.

3. How much time will I get in the property? That varies, but it is usually about 30 to 60 days from the time the agreement is reached with the agent.

4. Will I get a check upfront? Sorry, no. Most agreements call for payment when the property is vacant and in broom clean condition. The agent meets you at the property,  inspects it and gives you a check on the spot.

5.  Do I have to sign an agreement? Yes, you will have to sign an agreement that says the property will be delivered in good condition and the agreement will release the bank from any liability.

So if you are nearing the end of a foreclosure I would highly suggest  working out a cash-for-keys deal with the lender.  The bank will pay you to leave and that’s good for both parties.

After suffering through a foreclosure or short sale, there’s a final kick in the teeth. It comes in the form of a 1099 from your ornery mule of a lender.

For the last few years, with foreclosures in high gear, many homeowners were able to avoid paying tax on the 1099 issued after short sales and foreclosures because of the Mortgage Debt Forgiveness Act. The Mortgage Debt Forgiveness Act says that if a homeowner short sells his primary residence or is foreclosed on his primary residence then no tax is owed. This expires at the end of 2012.

What if they don’t extend this? There a few other ways to go as shown below.

First a little background:  A foreclosure or short sale creates what it is called cancellation of debt income.
Income tax has to be paid on cancellation of debt income. For a short sale, the amount that’s taxable is the difference between the amount owned under the mortgage and the amount actually paid back to the lender. For foreclosures, it’s the difference between the market value of the property and the amount due on the mortgage.

If you owned your home for any 2 of the last 5 years before the foreclosure or short sale, then no tax is due on the 1099 because of the Mortgage Debt Forgiveness Act. If you rented the home out temporarily, you will still qualify as long as you meet the any 2 of the last 5 years test. If the property was never your primary residence, then you can’t use the Mortgage Debt Forgiveness Act and tax will be owed on the 1099.
If the Mortgage Debt Forgiveness Act expires, (or if you had an investment property foreclosed or that was sold short) , there are only two ways to avoid paying tax on the lender’s 1099:

1. Claim Insolvency on form 982.
2. File Bankruptcy before the 1099 is issued.

Insolvency. Insolvency means that your debts exceeded your assets on the day that debt was forgiven. This worksheet explains how to calculate insolvency.  Notice that IRA and 401k accounts ARE included as assets. Overall, this seems like a simple calculation but it’s kind of tricky and anyone hanging their hat on insolvency should discuss it with their accountant well in advance of April 15. The insolvency worksheet should be filled out, form 982 is filed and then because you are insolvent no tax is owed on the 1099.

Bankruptcy. If a bankruptcy is filed before the 1099 is issued, then no tax is owed on the 1099. On your tax return, you file form 982 to show that you filed a chapter 7 or chapter 13 and that wipes out the income tax from the 1099

Foreclosures don’t seem to be slowing down and my bet is that the Mortgage Debt Forgiveness Act will be extended again.

This morning, I read with interest a story in the Wall St. Journal called “House is Gone But the Debt Lives On.” When I finished reading the story, my first thought was…this is going to freak out a lot of people unnecessarily.

(Aside: I read this on my Ipad and I highly recommend the WSJ tablet edition. It’s beautifully designed and very easy to read. It has a monthly fee, but it’s cheaper than the print edition).

The story covers how there has been an increase in deficiency judgments entered this year in a Florida community. A deficiency judgment is a court judgment entered against the owner after a foreclosure for the difference between the mortgage balance and the market value of the property.

The community is Lehigh Acres, an overbuilt central Florida boom town. It’s so bad down there that they could rename it “Deficiency Judgment Acres.”  In the first 7 months of 2011, there have been 42 deficiency judgments entered against foreclosed owners in this subdivision alone for more than $7 million.  Most of these judgments will be uncollectible, I would guess.

Here are the main points of the story:

1. Deficiency judgments are increasing in Florida.

2. Deficiency judgments elsewhere are still rare, unless the foreclosing bank is small bank or a credit union.

3. Down the line, debt collectors may buy foreclosed mortgages for two cents on the dollar and then may try to collect against foreclosed owners.

How does this apply to Illinois? Deficiency judgments are still rare in Cook County, so there is really no comparison to what is happening in Lehigh Acres.

It is always possible that foreclosed first mortgage debt could be dumped to debt collectors. I haven’t seen that happen yet, but you never know.

I’m always surprised that so many owners in foreclosure (including those who  strategically default) decide to move out of the property early in the foreclosure process. I’d say at least half leave the house as soon as they stop making mortgage payments.

In Illinois, foreclosure takes about 16 months (from the first missed payment) and the owner can live in the property and does not have to make payments during the foreclosure. So it makes economic sense to stay in the property as long as possible. But, many say they just want to “move on” or that they literally hate the property and can’t bear to stay there anymore.

Lately, I’ve seen an increase in the number of owners who move out of the property and then rent it out during the foreclosure process.  Is this legal? As our former Alaska governor would say, “You betcha”

There are some legal and tax consequences to renting the property and one should be aware of these before trying this.

1. Do I have to tell my mortgage company that I am renting the home? No.Can my mortgage company try to take the rent from me? No, not unless you signed an “assignment of rents” which is pretty rare.
2. How much rent should I charge? Most landlords charge slightly below market rent.  The  rental market is very hot these days. There’s usually no problem finding a tenant.
3. Should I do a credit check on the tenant? Yes, even though the property is in foreclosure, I would run a credit check on the tenant so that you don’t put Jack the Ripper in the house.
4. If I rent my house during a foreclosure, doesn’t that convert it to an investment property? Not necessarily. The definition of primary residence is pretty broad as detailed below.
5. Can I still call the house my primary residence if I rent it? The Mortgage Debt Forgiveness Act says that there is no tax due on the 1099 issued after a foreclosure if the property is your primary residence.  After a foreclosure, the owner gets a 1099 for the difference between the mortgage amount and value of the property.  The definition of primary residence is this: The owner used the property as his or her main residence for any two of the last five years. So, you can rent out the property for a few years and it will still qualify as your primary residence and there will be no tax owed from the 1099.
6. Should I tell the tenant the property is in foreclosure? Absolutely. You should be fair and honest about it and disclose to the tenant that the property is in foreclosure.
7. How long can I rent it out? In Cook County, you can rent out a property in foreclosure for about 14 to 16 months. It depends on what county the case is in and how fast the bank’s attorney moves the case along.
8. What about homeowner’s insurance? You should change tell your agent that you are renting the property and change your insurance accordingly. There are no contents to insure so the premium may go down. If you leave your homeowner’s insurance in effect and don’t tell your agent you are renting it, and later make a claim, it will be denied since you were not occupying the property.
9. Will the tenant be served with the foreclosure summons? Usually the tenant is not served with the summons. I has happened a few times lately. That’s one reason you should tell the tenant it’s in foreclosure.
10. How long can I collect rent? You can collect rent until the sheriff’s sale of the property which is at the end of the foreclosure. You don’t own it anymore after the sheriff’s sale.
11. Will the tenant be kicked out by the sheriff? The foreclosing bank gets an order of possession about 60 days after the sheriff’s sale (the sheriff’s sale  is about  12-14 months into the process). An order of possession can be placed with the sheriff and the tenant could be evicted.
12. Do I have to pay income tax on the rent I get? Yes.

This week I spoke to two clients, both of whom had six-figure salaries, about whether a short sale would be best for them.
High earner Case 1: Client was in the middle of a short sale (and was calling for a second opinion). He owned three properties and the one being short-sold was $100k underwater. It used to be his primary residence, but he rented it out for two years before starting the short sale. There were two mortgages. The first mortgage company wanted him to sign a promissory note for $8000 payable over 10 years. The second mortgage company wanted $10,000 cash contribution from him to allow the short sale. The client had $70k in credit card debt. The client wanted to know if he should complete the short sale or bail out and let the foreclosure be completed.

I would not have recommended a short sale in this case, because the client will have 1099 income after the short sale since this was not his primary residence. Also the second mortgage was refusing to release him from liability even though he had to pay them. He would have been much better off filing a chapter 13 bankruptcy which would vaporize the 1099, control the credit card debt with no interest and allow him to ditch all liability on the second mortgage.

High earner Case 2: Client bought a condo for his Mom (I can’t believe the number of people who bought properties for family members between 2004 and 2008-there are tons of them) Client earns $150k per year. Client paid $120k for the condo and put down 20%.  The condo is now worth $40,000! So the down payment is gone and the condo complex is riddled with foreclosures and short sales. In fact, the complex is close to being a zombie complex in which FHA or conventional financing can’t be obtained because of the lack of reserves and high delinquency rate. The condo dues were almost $400/mo. Since it was not his primary residence, there will be 1099 income after a short sale or foreclosure.

I like short sales where there is only one mortgage, but the client was reluctant to try it for two reasons: There will be 1099 income after a short sale and, due to his high income, the short sale lender would ask for a high contribution from him to allow the short sale to close. The client pretty much concluded it would be better to strategically default on the unit, skip the short sale and take the hit to his credit and pay the 1099 income at the end of the foreclosure.

Here are some of the problems with short sales and high earners:

1. No hardship. The owner is supposed to show a hardship. Sorry, but it’s going to be hard to come up with credible hardship letter when you make $150k annually. Luckily, most lenders are pretty flexible about what entails a hardship and it’s more likely that the lender will try to extract cash from you than deny your short sale for lack of hardship.

2. Have to furnish bank statements/ tax returns. High earners are very wary about furnishing bank statements and tax returns to the short sale lender. They are afraid that the lender will use this info to try to collect from them later. I have not found that to be the case, but this is a pretty pervasive fear among the high earner/short sale set. Most will not even consider a short sale when they hear that they have to hand over tax returns and bank statements.

3. Negotiator is a debt collector (not your friend). The lender appoints a “negotiator” to work on your short sale. This person is a glorified debt collector and once he or she sees your Vail ski condo or $75k in your bank account, they will ask you to contribute to the short sale. This is either in the form of a promissory note over 5 or 10 years or a cash payment. Both first and second mortgages may ask for contributions. I think contributions are fine as long as the lender releases the debt and forgives any deficiency. If the lender does not release any deficiency, what is the point of making a contribution? The contribution needed for release on a second mortgage will often be very high, making the whole short sale illogical at best.

4. Even if you keep current, credit will decline. Some high earners try to keep current on the mortgage payments during  a short sale hoping their credit will not suffer. Unfortunately, I have found that the credit score will still decline by 150-200 points after a short sale even if the payments are kept current.

5. Second mortgages are a pox. Any property with a second mortgage will continue to be a lingering problem after a short sale. It’s likely the second mortgage lender will file a collection action, get a judgment and garnish your wages after the short sale. So what exactly was the point of the short sale?

When to try it:

I think a short sale of  a primary residence is worth pursuing for a high earner who has only a first mortgage (no second mortgage) where the owner can get a release of liability. Even if the owner cannot get a release of liability it may still make sense, since most first mortgage holders don’t pursue the owner after a short sale closing.

When to pass:

Reluctant disclosers. Clients who are wary of disclosing tax returns and pay information to the lender should not consider a short sale.

Second mortgages. There is rarely a reason to short sell a property with a second mortgage because it’s likely the second lender will pursue you after closing and your credit will decline as much as a foreclosure. Or they will ask for a large contribution, making the whole thing uneconomical.

Investment properties. For investment properties, the 1099 income after a short sale will be brutal. Also, the lender may pursue you for a deficiency, so it’s often better to consider filing a chapter 13 bankruptcy to erase the 1099 income and release any deficiency balance. Most high earners won’t meet the strict means test to qualify for a chapter 7 bankruptcy.

Masochism alert: If you want to get good and depressed, look up your house on zillow this month.Type your address into www.zillow.com. When your property pops up, click on your address, above where it says “zestimate.” The next screen will show the 30-day price change. This showed my house down $35,000.00, not for the year, just for January.

Wowser, that’s one wicked drop.

There has to be a bottom coming for real estate values, but it is not here yet. The seemingly never-ending  slide of real estate values is also causing high income earners, who can otherwise afford their mortgage, to strategically default on their homes (and second homes) because they have lost hope that the market will rebound in their lifetime.

This excellent post on Dr. Housing Bubble points out that strategic defaults increase greatly once a home is underwater by more than $100,000.00. Also, if the neighbors start walking away the chances are others will do the same. Those with large mortgages and high credit scores are more likely to strategically default on their mortgages than those with small mortgages and low credit scores.

I do telephone consultations with clients almost daily and many of these clients earn $100,000.00 or more and can pay their mortgages, but several factors are pushing them toward strategic default:

1. They can rent a house that is much bigger and in better shape than the one they own for less than they are paying on their mortgage.
2. They are $100,000.00 or more underwater and have lost hope that the home’s value will rebound in a reasonable time. With each big drop on zillow, more people go sub-$100k and the likelihood of their strategic default increases.
3. They view the only negative of strategic default as being the hit to their credit score.

These clients are well-educated and they look into a strategic default  carefully before actually doing it. Most tell me that they have talked to several attorneys about the process.  I have to say that it seems to me that most have already made up their minds to quit paying on their mortgage and I have a hard time convincing them otherwise. Supposedly, all the high earners walking away from their mortgages frees up cash that’s spent on other things and gets the economy rolling (this is kind of a stretch).

There are many negatives to consider for a high earner before walking away from an existing mortgage. Some of these are:

1. Constant phone calls from the lender. Receiving several calls per day for more than 1 year can wear people out. This is the biggest complaint that I hear from clients who are in the foreclosure process.
2. Getting served with the summons by the sheriff. This is a terrible day for all but the most tough-skinned. Worse is being served at work by the sheriff (this rarely happens).
3. Trashing of credit score. Credit will go to 520 and stay there for awhile.
4. Association must be paid and will pursue you vigorously. If there are dues owed to a condo or townhouse association, these have to be paid until the foreclosure is over.
5. Second mortgage must be paid or settled. Second mortgage companies will file collection actions against clients. I highly suggest that no one quit paying a second mortgage unless they are ready to file a bankruptcy, because the second lender will be like a hell hound on your trail. I just filed a bankruptcy for a client who quit paying on a house that had a second mortgage. Two years after the foreclosure, the second mortgage company sued, got a judgment for $40k and was about to garnish his wages. So, a strategic default that involves a second mortgage is a very real financial threat and should not be done unless you are willing to pay the second mortgage or file banktuptcy.
6. First mortgages are not pursuing deficiency judgments, but this could change. Right now there are really no deficiency judgments being taken in Illinois and no collection actions being filed by first mortgage holders. What if this changes and the foreclosing lender dumps the foreclosed notes to a debt collector in the future? What if lenders start to seek deficiency judgments in Illinois? Things can always change, although I think this is unlikely.
5. Biggest worry of high earners: That the foreclosing bank will get a deficiency judgment and take other assets from the client. Clients are absolutely obsessed with this. First, the likelihood of a deficiency judgment on a first mortgage is slim. Right now, the only time this can happen is with a second mortgage, as discussed above. But clients wring their hands about this and worry that the lender will creep up on them down the line and take their cash or a new home bought in their spouse’s name.  This is not likely to happen.

This post titled Not Walking Away is For Suckers and For People Who Aren’t Rich, kind of sums the high earner/strategic default issue, better than I could.

Strategic default is not funny.

But the video below from “The Daily Show” talks about how the Mortgage Bankers Association strategically defaulted on its own building, yet instructs everyone else to stay put.

Also interesting in today’s Wall Street Journal is “The Great Mortgage Mystery” that starts with this rather eye-opening lead:

“The big question from the mortgage meltdown isn’t why so many distressed homeowners are defaulting on their loans. It’s why any of them are still making payments.”

The story also uses the term “zombie homeowners,” that is  borrowed from the Japanese “zombie banks,” to define underwater homeowners.

Read or browse the 150 plus comments to the WSJ story.  Because strategic default is such a volatile topic, the comments are as good, if not better than than story.