Monthly Archives: January 2011

High earners & strategic default

foreclosures-shortsales, Strategic Default

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.

Hammer time: 1099s coming soon for 2010 foreclosures

foreclosures-shortsales
The first week of February 2011 will be bleak for those that went through a foreclosure in 2010. That’s because lenders are required to issue form 1099 after a foreclosure and the 1099s are usually received that week.

Some ignore the 1099 and don’t claim it as income and have problems with IRS for years to come. If there’s one piece of advice I can offer to those who were foreclosed in 2010 (and there were many of you)  it’s this: Don’t ignore the 1099. For most, the foreclosure was of their primary residence, and luckily there is an exception for primary residences through 2012 that makes the foreclosure tax free, but that doesn’t mean you can ignore the 1099.

For those who had an investment property foreclosed, or a property that was not their primary residence, it is truly hammer time and all I can suggest is please, please get some good tax advice asap.

Here’s how the whole 1099-after-a-foreclosure thing  works. The lender must issued form 1099-C which is titled “Cancellation of Debt” after the foreclosure. This does not mean the mortgage debt is cancelled. It means that the lender is reporting to IRS that the debt was cancelled. Cancelled debt is taxable. Fortunately, you will not owe income tax on the entire amount of the 1099, just a portion of it.

Here’s how cancellation of debt is calculated:

Step 1: Take the total amount of the debt at the time of the foreclosure. If your mortgage was $200,000 and there was an additional $10,000 in interest and attorneys fees, the total, for example would be $210,000.00.

Step 2. Subtract the fair market value of the property as shown on the 1099C. Usually the lender reports this on the 1099, but if not, you will have to determine the value. Let’s assume the value of the property was $150,000.00

Step 3. The result is $60,000.00 that is taxable to the foreclosed owner in 2010.

Fortunately, there are three ways to completely knock the 1099 out of the tax picture and make it totally nontaxable. That is where form 982 comes in. The 1099 is shown as income on your tax return, but then it is subtracted by filing form 982, so the net effect is no additional tax. Here are the three ways to avoid paying taxes on the 1099 and these are shown on form 982:

1. Taxpayer filed bankruptcy. If a chapter 7 was filed before the 1099 was issued no tax is due. One cannot wait until after the 1099 is issued to file bankruptcy, it is too late then. The case has to be filed before the 1099 comes out.

2. Insolvency. The taxpayer is insolvent, in other words,  the debts exceed the assets. I want to caution that this is not as easy as it sounds and you absolutely, positively have to talk to a tax professional about this well in advance of receiving the 1099.

3. Primary residence. If a primary residence was foreclosed, then no tax is due on the 1099. This exception only runs through 2012. A primary residence is a property used as your primary home for any 2 of the last 5 years.

So those whose primary residences were foreclosed will be fine, but those who had investment properties foreclosed are left with only two remedies: File bankruptcy before the 1099 hits or claim to be insolvent.

The fact that you received a 1099 does not mean that you the lender has given up getting a deficiency judgment against you. In most cases, the lender will not pursue you for a deficiency judgment if a first mortgage was foreclosed and the lender issued the 1099 to you. Technically, the lender could still pursue you for deficiency judgment even after a 1099 was issued, but I am seeing no deficiency judgments for first mortgages here in Illinois.