Be Wary of Offers of Help When Facing Foreclosure
If you’re one of the many strapped Southland homeowners facing possible foreclosure or trying to get your lender to accept a “short sale” of your home, several new companies claim they can minimize your woes.
Boston Harbor Corp., based in San Diego, advertises that it “has found a way to solve your problems.” Homes America, headquartered in Los Angeles, says it “will help solve all your problems today.” New England Financial Corp., based in Riverside, also offers to help out property owners in a bind.
If you think this sounds too good to be true, you may be right. The methods used by the companies to help troubled homeowners are controversial--to say the least.
The Internal Revenue Service is warning that it may not treat these transactions favorably and that property transfers to these companies are risky.
Prosecutors, consumer advocates, credit bureaus and lenders are also raising red flags about the companies’ programs.
Here’s how the companies work:
When a lender forecloses on a homeowner, that foreclosure usually remains on the debtor’s credit report for seven years. But a growing number of borrowers with no equity in their homes are trying to avoid foreclosure by selling their homes and getting their lender to agree to a “short sale,” or “short payoff,” in which the lender accepts the proceeds of the sale and forgives the borrower any difference between the sales price and the loan balance.
There are two hitches, however. First, the borrower has to persuade a wary lender to go along with the short sale. Second, any debt that is forgiven by the lender is considered taxable income by the IRS and the California Franchise Tax Board.
Boston Harbor, Homes America, New England Financial and other similar companies claim they can help homeowners by taking over the house, and then, as the new owners, trying to negotiate with your lender.
The charge for this is 1% of your original mortgage balance.
The companies say that signing over to them the deed to your house can save you from paying any debt forgiveness tax and that they may save your credit rating too. You, however, remain responsible for the loan.
If the lender agrees to a short sale, you won’t be liable for any tax on debt forgiveness because you didn’t own the home when the debt was “forgiven,” the companies say.
If there’s a foreclosure, say the companies, you can always claim to credit reporting bureaus that it shouldn’t appear on your credit history because you didn’t own the home when the lender foreclosed.
The tactic has been spreading over the last year, but the IRS still doesn’t seem to know what to make of it.
IRS officials are warning consumers that the government is still reserving the right to collect tax for debt forgiveness “income"--even if a property has been transferred to a company such as Boston Harbor, Homes America or New England Financial.
“It’s quite a controversial situation. Homeowners need to be very careful about entering into these types of agreements,” said Christina Navarret-Wasson, a spokesperson for the IRS in Los Angeles. “It’s a risky venture at best.”
The Los Angeles District Attorney’s office is also studying the practices of companies such as Boston Harbor. “We asked one of our investigators to start research. We’re sort of in the early stages,” said Mike Carroll, head of the D.A.'s major fraud division. “There is no free lunch, so be careful what you do,” Carroll advised homeowners.
Richard Pittman, director of counseling at the nonprofit Consumer Credit Counseling Service of Los Angeles, agrees. “I generally tell people to avoid this type of a property transfer like the plague,” he said. “Consumers who can’t keep up with the mortgage should explore every other option first.”
Pittman also questions the claim that the transferring the title to a property before a notice of foreclosure or before a trustee sale helps save a borrower’s credit report from being blemished. While credit reporting agencies might be persuaded to remove a foreclosure from the record, they will retain a record of the fact that the lender was not paid in full for its loan, Pittman said.
“The fact that the customer transferred title does not negate the consumer’s liability to the lender,” said Martin Dee, spokesman for credit reporting giant TRW Information Services in Orange.
“Boston Harbor claims that it has been successful in removing negative elements from a borrower’s credit report--but if it has happened, we’re not aware of it,” he said. “Even if the lender does accept a short sale, it can still negatively affect the borrower’s credit report.”
Lenders are also challenging the claims and practices of companies such as Boston Harbor, Homes America and New England Financial. “We don’t recognize the property transfers as valid,” said Tim McGarry, a spokesperson for Chatsworth-based Great Western Bank. “We still will report any debt forgiveness to the IRS and the borrower continues to be named in reports to credit bureaus.”
The Federal National Mortgage Assn., which buys millions of mortgages from lenders in the secondary market, issued a memo to lenders who service millions of Fannie Mae mortgages telling them:
“If one of these third-party companies contacts the servicer of a Fannie Mae mortgage about accepting a short payoff for a property . . . under no circumstances should the servicer negotiate the short payoff.”
The memo also tells lenders to continue to report mortgage delinquencies in the borrower’s name and to hold the borrower liable for the loan.
“We expect lenders to adhere to the policy,” said Gwendolyn Minton, vice president of loan servicing and lender standards for Fannie Mae in Washington. “There’s nothing that we can do now to stop a transfer,” Minton conceded. “But we’re in the process of researching the legality of these practices.”
Borrowers are better off talking with a lender directly instead of handing over title to their home to a third party, Minton said. Once a borrower signs over title to a third party, she said, lenders will in fact be less flexible in working out a deal with borrowers.
There are other possible problems for owners contemplating a transfer of their title. Here’s one example:
Jane Homeowner is no longer able to afford the residence she bought three years ago for $190,000 with a $160,000 mortgage. Today, the loan balance is down to $150,000, but the home is only worth $130,000. What should she do?
If Homeowner lets the lender foreclose, the IRS considers this a sale for the value of the loan. While she owes no taxes for debt forgiveness, she now has a checkered credit rating. If she finds a buyer willing to pay $130,000 and she persuades the lender to accept that as payment in full, Homeowner will owe taxes on $20,000 in debt forgiveness.
Boston Harbor, Homes America and New England Financial say they can help negotiate a short sale and help Jane avoid the tax she would otherwise have to pay for the debt forgiveness. If the lender won’t agree to a short sale, the companies claim that they can help keep the foreclosure off Jane’s credit report. Both of these claims are not guaranteed, however.
The situation becomes even more complicated if Jane were carrying forward the gain from a previously owned property into the one she now owns. If she made $100,000 on her previous residence, then her “tax base” on the current property is $90,000 instead of $190,000. In that case, a short sale for $130,000 would yield a capital gain of $40,000, for which additional tax has to be paid.
But it gets worse. If Jane had transferred her residence to Boston Harbor, for example, the value of the transfer would be assumed by the IRS to be $150,000. Her taxable capital gain then becomes $60,000 instead of $40,000.
Companies such as Boston Harbor are mentioning to homeowners that they may be liable to the IRS for capital gains tax, but many people don’t fully understand the complexities involved. Boston Harbor has produced a 22-minute video explaining how homeowners can avoid the tax implications of a short sale. The video does not mention anything about the potentially ruinous affect of having to pay more taxes on capital gains.
Such capital gains can only be avoided when a homeowner has the wherewithal to rollover the gain into another home within two years. This, of course, is easier said than done for a family already facing financial ruin.
Eric Fagen, a San Diego attorney and president of 18-month-old Boston Harbor Corp., insists that his tax-avoidance scheme is perfectly legal and effective.
“I believe the IRS would have stopped this practice if they could have by now--but they haven’t,” he said.
The whole process is simple and straightforward, Fagen said. Homeowners sign a grant deed that hands over the property to his company--along with a check to the company for 1% of the original loan balance. And, while Boston Harbor won’t assume the loan, it does take the property subject to the lender’s security interest on that property. Because Boston Harbor buys the properties as a business “investment,” it doesn’t end up paying income taxes for debt forgiveness.
All told, Fagen said, Boston Harbor has taken over title to about 1,200 properties, about 70% of which are in California. Only a portion of these properties have been sold with the consent of lenders to a short sale. The majority of properties are still awaiting some sort of resolution.
According to data provided by the realty information company DataQuick, Boston Harbor, at the end of 1994, held title to 194 properties in Los Angeles County, 62 in Orange County, 39 in Riverside County, 26 in San Bernardino County and three in Ventura County.
Loans average about $150,000 to $200,000, Fagen said. Homeowners can stay rent free in their residences anywhere between a few weeks and a few months between the time that they sign over title to their properties and the time that the lender either agrees to a short sale or concludes a foreclosure.
Homes America, which has been in business for about seven months, has acquired about two dozen properties, but it has concluded successful negotiations with lenders for a short sale in only three cases, admitted Ken Marker, a licensed real estate broker and acquisition manager for Los Angeles-based Homes America. Marker also conceded that “there is no definite law on this.” But, he said, “the homeowners are not risking much.”
Like Boston Harbor, Homes America does not go into depth with homeowners about the tax basis of their homes. This is essential, though. Capital gains are taxed by the feds at about 28%, while the “ordinary income” of debt forgiveness is taxed on a sliding scale of 15% to 39%, depending on your tax bracket.
Besides the potential capital gains hit, homeowners may also have to contend with a deficiency judgment.
The companies that offer to help with short sales say that they can’t insulate homeowners from potential deficiency judgments, where homeowners are personally responsible for any difference between their debt to a mortgage lender and the amount of money generated by a foreclosure sale.
They maintain, however, that a deficiency judgment is unlikely for most homeowners. California law protects borrowers from deficiency judgments if borrowers have a purchase-money loan on their home and have not refinanced it.
California law also protects borrowers from deficiency judgments when a lender chooses to exercise its rights under a deed of trust and foreclose through a trustee as opposed to going to court. This is known as non-judicial foreclosure.
However, if your loan is not the one you used to buy the home, a lender could opt to foreclose judicially and then go after you for a deficiency judgment. Because of the time and expense associated with judicial foreclosure, most lenders opt to foreclose non-judicially and give up their rights to a deficiency judgment, said Andrew Smith, general corporate counsel for New England Financial Corp., a Riverside-based company incorporated in June, 1994, that now says it controls about 300 properties. If a borrower has significant assets, though, many lenders will consider--or at least threaten--a judicial foreclosure.
If there is a second or third mortgage on the property in question, the threat of a deficiency judgment is more serious. The holder of a second or third mortgage may sit back as the first forecloses and then pursue the now-former homeowner for a deficiency judgment to pay their loan balances.
There’s still more complexity to a borrower’s tax obligation when there’s a foreclosure or debt forgiveness. First, when a debtor is insolvent, the IRS won’t hold the debtor responsible for the debt cancellation to the extent of the debtor’s insolvency. Second, if there’s a foreclosure, a debtor who is personally liable for a debt may also have to pay tax for debt forgiveness.
While owners of commercial property can now defer any “income” that results from debt forgiveness if they own another commercial property, residential property owners don’t have the benefit of such a loophole. The Republican Contract With America has a provision that--if approved--would allow taxpayers who sell their homes to claim losses that may offset other income.
The bottom line is this: Consult an attorney, CPA or trained credit counselor for professional help before you do anything.
Galperin is an attorney and a principal in Real Estate News Group, a Beverly Hills-based real estate news and features syndicate. He also writes the weekly “Property Values” column for the San Fernando Valley and Ventura County editions of The Times.