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Friday, December 18, 2015

Housing Crash Persists for Many

As remarkable as it sounds, even though it's been almost a decade since the peak of the housing bubble, RealtyTrac recently reported that there are still almost 7 million residential properties that are "seriously underwater," which it defines as any property where the outstanding mortgage balances exceed the property's estimated value by at least 25%.  The housing data provider estimates that approximately 13% of all residential properties with a mortgage are still seriously underwater.

So, what does this mean for people who are this far underwater and can no longer make their mortgage payments?

Tax Implications of Walking Away
People are frequently surprised when they find out that they could end up owing taxes on "cancellation of debt income" after going through a short sale or foreclosure.  This happens when property is underwater and the bank recovers less through the short sale or foreclosure than was owed under the mortgage.

Depending on the circumstances, the bank may decide to sue the homeowner for the deficiency after a short sale or foreclosure.  If and when the bank comes up empty, it will cancel the debt.  When the bank cancels the debt, it will issue a 1099-C, which reports to the IRS the amount of the debt it cancelled on its books.  This amount is reported as income to the borrower.  The bank does this because the money that was given to the borrower in connection with the mortgage loan is no longer expected to be repaid, so it counts as income.

Depending on the borrower's financial situation, this cancellation of debt income may constitute a taxable event.  One way the borrower can avoid tax liability on the cancelled debt is if the borrower is insolvent (i.e., total liabilities exceed total assets), but only to the extent the borrower is insolvent as of the date of the debt cancellation.  This can be a complicated exercise, and may require the assistance of an accountant to determine the extent of any tax liability.

Bankruptcy as a Solution to Tax Problem
It's important to note that the IRS's insolvency definition requires borrowers to include their retirement accounts as assets in the calculation.  If a person has more than a few thousand dollars in his or her retirement accounts, this can make it much more difficult for borrowers to establish that their insolvency was greater than the amount of the debt cancelled.  By contrast, funds held in a tax sheltered retirement account like a 401k or IRA can be protected in a bankruptcy.  This means you can avoid a potential tax hit on cancellation of debt income if you file bankruptcy.

But Delay Could be Costly
If a borrower files bankruptcy before the bank cancels the debt, any money owed to the bank will be eliminated (the legal term is discharged) as part of the bankruptcy.  Debts discharged in bankruptcy are never taxable. 

However, if the borrower does not act until after he or she receives a 1099-C, any income taxes owed on that cancelled debt cannot be discharged in a bankruptcy filed in the next 3-plus years.  This means that if you wait until you receive a 1099-C, you can't get the benefit of a bankruptcy discharge with respect to any income taxes arising out of the debt cancellation for at least another three years.

If you've recently gone through a foreclosure, short sale or principal reduction (or are considering one), and you're being pursued by the bank for a deficiency, or if you're concerned that you may have cancellation of debt income, please give me a call to discuss if a Chapter 7 bankruptcy could put these matters to rest.