YOUR MORTGAGE : Controversial Programs Avoid Foreclosure, Tax
A top home mortgage industry executive calls it “pushing the envelope of the law” and vows to fight it nationwide if necessary.
Officials at the Internal Revenue Service say they’ve recently become aware of it and are studying its possible tax implications for participating homeowners.
What they’re talking about is 1994’s latest, creative wrinkle in mortgage credit:
Companies that offer financially distressed homeowners a way to avoid foreclosure, negative marks on their credit bureau files and--most significantly--large tax liabilities to Uncle Sam.
Lenders say such enterprises have been encouraged by a 1993 federal tax code change that requires lenders to report “debt relief” they extend to borrowers in excess of $600.
Here’s how the concept works. Say you bought your home at the top of the market cycle several years ago, and you know its sale value today is less than the mortgage balance. To compound matters, your spouse’s employer closed last year, cutting your family income by 40%.
You’ve been missing mortgage payments and you’re staring at the grim reaper of foreclosure two or three months down the road. What to do? There are several options, but the one that’s bothering lenders involves deeding your property over to a third party. The “purchaser” makes no payment to you, but agrees to become the owner of legal record on the property.
A firm active in this field is Boston Harbor Corp., based in San Diego. For an upfront fee equal to 1% of your original mortgage principal balance, the firm steps into your shoes and immediately contacts the lender. The first thing Boston Harbor says to the lender, according to its general counsel, Eric F. Fagan, is that “there will be no further payments” on the loan. Instead, the firm will provide a service free of charge: It will sell the property quickly at the best price it can get--often less than the loan amount--and turn the net proceeds over to the lender.
“The advantage (to mortgage lenders),” according to Fagan, “is that they avoid all the expense and time of a foreclosure” as well as the possibility of having to hold the property in portfolio for months or years as REO--real estate owned.
The attractions to the erstwhile homeowners? Several, in Fagan’s view. First, they get out of the financial jam they were in. Second, they avoid the Scarlet Letter on their credit report that would haunt them for years following a foreclosure. Even if their lender ultimately did take back the house, the party foreclosed upon--the legal owner of the property--would be Boston Harbor, not the original homeowner.
Finally, if the sale of the property yielded less than the mortgage balance, the homeowners would avoid the sticky tax trap known as “debt relief.” Under the federal tax code, any relief of indebtedness on behalf of a borrower constitutes taxable income to the borrower.
For example, say the foreclosure sale of your home, with your name on the property deed, yielded $125,000 but you owed $150,000 to the bank. If the bank licked its wounds and walked away, your debt relief on the transaction would be $25,000. In the 31% marginal tax bracket, that could mean you owe $7,750 in additional federal taxes. And under a provision of the 1993 tax law, the bank is now required to report your $25,000 in debt relief to you--and to the IRS--on tax form 1099. The law mandates such reporting for all debt forgiveness over $600.
If Boston Harbor’s name was on the deed, however, argues Fagan, the debt relief would go to Boston Harbor. As a corporation that buys and sells houses, it would be able to offset the $25,000 “income” (debt relief) against the $25,000 paper “loss” it recorded on the sale. Fagan’s program defines the price it pays for a house as the outstanding mortgage balance at the time of acquisition.
The homeowners’ tax position after all this? According to Fagan, presto: They’re out of the loop. They owe neither Uncle Sam nor their former lender a cent. Boston Harbor, meanwhile, has pocketed 1% of the original loan balance in cash. That’s $1,500 on a $150,000 mortgage, $3,000 on a $300,000 mortgage.
Fagan says business is booming. By his count, the firm has initiated or completed over 100 transactions in the past six months alone. But that doesn’t necessarily sit well with lenders. Richard D. Bryan, an executive vice president at Freddie Mac, the Federal Home Loan Mortgage Corp., says the firm is encountering more of these transactions and vigorously opposes the concept.
By encouraging homeowners to walk away from their financial obligations and promising tax and credit-file benefits, said Bryan, such firms are “pushing the envelope of the law.” Freddie Mac, for its part, will send 1099s and report foreclosures in the original borrowers’ names, Bryan warned.
The IRS, in the meantime, says it is “looking at” the whole subject of mortgage debt relief. Asked if he had contacted the IRS for an opinion to safeguard his homeowner clients, Fagan confirmed that he had not. His own tax attorney cleared the plan, according to Fagan.
The upshot on mortgage debt relief programs for consumers: Be aware that they’re controversial at the least. Get solid legal and tax advice before plunging ahead.
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Distributed by the Washington Post Writers Group.
