I once asked an accountant why a homeowner had to face a surprising penalty from the Internal Revenue Service after losing his job and his home because of a downtown in the economy.
When the homeowner had to sell his home for less than its purchase price (known as a short sale), the bank also forgave a portion of the mortgage. The amount forgiven, $15,000, showed up as taxable income on the homeowner’s tax return.
According to the accountant, the initial intent of the law was not to further penalize distressed borrowers. The initial idea was to find a way to account for parents and friends who provide seller financing for their children and associates and then simply forgive the debt once the kids have settled in to the new home.
Regardless of the roots of mortgage forgiveness penalties, many borrowers today are facing higher payments and possible default and foreclosure resulting from the upward adjustment of an adjustable-rate mortgage. Whether it is a conventional ARM leaping from 4.5 percent to 6.5 percent or a subprime loan tied to a high-interest-rate second mortgage and a prepayment penalty, the possibility of a home-sale loss or short sale is higher now than in nearly a decade.
While there is a move afoot in the nation’s capital to keep a lender’s mortgage forgiveness from being classified as income, there is no federal income tax deduction for losses accrued on the sale of a primary or secondary residence. The principal residence has always been viewed as a personal asset. The gain on the sale of a principal residence has been taxable as a capital gain (after the $500,000 exclusion for married couples and $250,000 for single persons), but losses have never been allowed. Although the capital gain thresholds have been increased in the past 10 years, previous proposals to address capital losses have been defeated.
Given the occurrences of the past few months, most lenders will bend over backwards to help borrowers who are behind. Many have longstanding, alternative loan payment programs available, while others have installed new packages — especially for genuine subprime victims.
Alternative programs for mortgage payments are typically lumped into one category called “forbearance.” Forbearance is not free, nor does it mean forgiveness. It usually is a short-term agreement between borrower and lender permitting partial payments until normal payments can be resumed. Typically, forbearance agreements run three to six months.
Credit reports will show delinquent payments when full payments are not received. So, if you make partial forbearance payments for a short period, it’s best to petition credit bureaus to remove any “black marks” after full payment has been made. Explain the circumstances to the credit bureau in a letter to protect your future credit.
Forbearance does delay foreclosure, the process by which a homeowner who has not made timely payments of principal and interest on a mortgage loses title to the home. The foreclosure clock starts ticking once the borrower is in default. A borrower technically is in default one day after a payment is due. However, most lenders do not mail the borrower a Notice of Default until two to three payments are missed.
Most mortgage bankers do not eagerly await a default on the family home. Bankers are in the business of loaning money and they do not wish to have your home back. It takes considerable time and money (about $100 a day) to manage and maintain foreclosures. Lenders would prefer to spend their energies on processing applications and recruiting customers.
If you have little or no equity in your home and wish to stay there, the lender probably will be more agreeable to adjusting your mortgage contract if you can show that you will be able to repay the debt with a lower-paying job.
However, remember that while a lender will help solve temporary financial problems, a permanent financial setback could result in having to sell the home — especially if you have significant equity. The lender is out to avoid, or cut, his losses, and your equity will provide that assurance. If you must sell, you will avoid delinquencies, keep your credit rating, and retain the equity in your home.
If you are facing mortgage problems, conduct a genuine assessment of your future possibilities. Perhaps you can dip into savings to get you over the hump. Then, talk to your lender and explore all options. If you don’t ask, you’ll never know what’s possible.
To get even more valuable advice from Tom, visit his Second Home Center.