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Thursday, October 14, 2010

FORECLOSURE CRISIS: HOW CONGRESS RIPS OFF DISTRESSED HOMEOWNERS

 Income Tax Effects of Foreclosure or Deed in Lieu of Foreclosure
THE "FORECLOSURE WINDFALL PROFITS TAX"
By JC Leahy, MA Accounting

I arrived home from work and noticed my neighbors sitting on the curbside in front of their house.  They were a middle aged Hispanic immigrant couple.  She was an attractive woman who generally dressed well and drove off every day to some job.  He was a small contractor hard hit by the recession.  His biggest prime contractor had failed to pay him, toppling his finances like a row of dominoes.   His bank had repossessed the family home.  He didn’t even manage to remove all their belongings. The were locked out.  I approached them to talk.  He was friendly but avoided my eyes and hesitated when he talked, giving the impression of being ashamed and crushed – emotionally demolished.  She seemed horrified, involuntarily fidgety, trying to be stoic, unsuccessfully fighting back the tears.  Their son was nowhere to be seen.  I offered to put them up at my house.  He thanked me but said that their son had been sent to a relative.  He said there were good tools in his shed and I should grab what I wanted because he had no way to transport them and nowhere to store them.  He didn't realize the shed was already padlocked.  He, himself, would bunk at another relative, and she would go somewhere else.  He still had some tools and he said he would work hard and  try to rise from the rubble and pull his family back together.  He didn’t yet realize that he had  big potential problems with the Internal Revenue Service  – courtesy of the clowns who represent us in United States Senate and House of Representatives. 
The income tax problem for the down-and-out property owner is twofold:  First, when the bank snatches your house – whether your home or your rental property – the tax law views that as a SALE of the house.  Viewing a foreclosure as a sale can crush you with big capital gain tax, especially if you have owned the house for a long time.  The second problem is that after you lose your house and the bank sells it at auction and the paltry proceeds don’t satisfy the mortgage – if the bank doesn’t come after you for the unpaid mortgage balance, the Internal Revenue Service views that as a big windfall for you  –  which means income that is fully taxable.  In summary, not only do you get to lose your house, but in the process you may realize a big capital gain and a huge windfall other “income” leading to a giant tax bill and the wrath of the IRS.  Sigh….I kid you not!!  So pay close attention.  Here are the details.  I like to call this set of problems the "Foreclosure Windfall Profits Tax."


There are 2 kinds of foreclosure: judicial and non-judicial.   Judicial is when the bank goes to court and gets a foreclosure through the court.  A trustee foreclosure is when the property is held by a trustee and a trustee sale is made without having to go to court.  There is also a way to avoid the hassle of an actual foreclosure called a “deed in lieu of foreclosure.”  This is when the property owner signs the property over to the bank in exchange for the bank’s agreement to let him off the hook for the mortgage balance in excess of whatever the house brings in at auction.  The property owner might prefer the deed in lieu of foreclosure because he can be sure the bank won’t be dogging him for years for the unpaid mortgage.  The bank, on the other hand,  might prefer NOT to take a deed in lieu of foreclosure for exactly that same reason.  More likely, however, the bank might prefer NOT to take a deed in lieu of foreclosure because it does not wipe out any second or third mortgages – home improvement loans, lines of credit, or similar junior loans secured by the house.  A foreclosure, on the other hand, will effectively wipe out the junior secured loans.  But from the IRS’s point of view, judicial foreclosure, non-judicial foreclosure, and granting a deed in lieu of foreclosure are all treated exactly the same.
To calculate your Foreclosure Windfall Profits Tax, you will need three key numbers: (1) the adjusted basis of your house, (2) the fair market value of the house at time of foreclosure, and (3) the balance of your mortgage at time of foreclosure.  Of these numbers, the easiest one to obtain is your mortgage balance.  Just look at your mortgage statement or ask the bank.  The fair market value of your house is trickier.  After all, who can say?  Generally, the FMV of your house is measured by what the bank is able to sell it for after foreclosure – THAT figure is the fair market value of the property. 
Probably the hardest number to come up with is the adjusted basis of your property.  This takes a little fact-gathering and arithmetic.  Here’s the formula for computing the tax basis of your home or rental property:
Original basis + capital improvements + selling costs – past depreciation on your house – past depreciation on your capital improvements = adjusted basis
The “original basis” in the above formula is what you paid for the house plus certain closing costs.
Here’s a link to a handy calculator for your property’s adjusted basis:  ADJUSTED BASIS CALCULATOR
Now that you have the 3 key numbers, you are ready to compute your capital gain and your “foreclosure windfall income” – which the literature calls “cancellation of debt income.”
CAPITAL GAIN OR LOSS
Capital gain from a foreclosure is equal to amount realized minus the adjusted basis.  It’s that simple. In a foreclosure involving a non-recourse mortgage, the amount realized is the mortgage balance.   In a foreclosure involving a recourse mortgage, the amount realized is the lesser of the fair market value of the property or the mortgage balance. If the result of the subtraction is negative, then it is a capital loss.  If you have a capital gain, then you parse it as such.  This means that if the capital gain is from the “sale” your principal residence, you may be able to use your $250,000/$500,000 exclusion to avoid taxes.  If, however, the house was your second residence, or vacation home, or rental property, you must pay income tax on the full capital gain.  If you have a capital loss, you may not claim ANY of it EVER, unless the house was a rental property - in which case it is treated as an investment.  For a  rental property, your capital loss may offset other capital gains if you have any.  If not,  you may claim $3,000 per year every year until you use up the total amount of the loss. 
FORECLOSURE WINDFALL INCOME – AKA CANCELLATION OF DEBT INCOME
Your cancellation-of-debt income is equal to the cancelled balance of the mortgage minus the fair market value of the property.  It’s that simple.  This can be a very big number and a rude shock to the down-and-out erstwhile homeowner, who thought he lost everything but is now told that he has huge chunk of windfall “income” and a consequent huge chunk of income tax liability.
 Fortunately,  in 2007 President Bush signed the Mortgage Forgiveness Debt Relief Act which allows many, but not all foreclosed, homeowners to avoid a crushing tax bill.  Under present law, you do not have to include your “foreclosure windfall income,” (aka cancellation-of-debt income or forgiveness-of-debt income) in your tax return if you fit under one of these exceptions:
  1. The house was your principal residence and the mortgage money was used to buy or improve it.  See my recent Journal article for the details of this exception.
  2. The mortgage was discharged in a bankruptcy
  3. You were insolvent at the time of foreclosure.  Insolvency is a technical term that simply means that the sum of your debts exceeds the sum of the fair market values of your assets.  To the extent of this excess, your cancellation of debt income will be non-taxable.
  4. Certain farm debts
  5. The mortgage was a non-recourse debt.  Forgiveness of non recourse debt does not result in cancellation of debt income.  “Non-recourse” means that under the terms of the particular original mortgage or related state law, the bank has no final recourse besides taking the house and selling it for the proceeds.  In other words, you aren’t liable for the remaining balance.
  6. There is also an exception for certain business property, but rental property is NOT business property, so this exception does not apply to repossessed houses.  It would apply, for example, to a repossessed retail store.

REAL LIFE EXAMPLE

You have all the information you need to make Foreclosure Windfall Profits Tax calculations.  To show you how this all works, here's a real life. actual example.  Obviously, the names have been changed to protect privacy.

Mag Scratch is in her late 60's. She wanted to retire to Florida. She bought a condo there for $175,380, which, at the time,  seemed like a great bargain. She made a $30,000 down payment on the condo, using a recourse mortgage.  Unfortunately, she was subsequently unable to sell her home in Maryland, so she was burdened with 2 mortgages.  She couldn't retire at all.  Need for employment kept her in Maryland.  To help cover the mortgages, she rented out the condo in Florida.  She had trouble renting the condo, so even with what rent she could get, she could not afford the 2 mortgages.  As a result, in 2009, the bank foreclosed on the Florida condo.  The bank took the "deed in lieu of foreclosure" route.  The bank then sold the condo for $30,000.  Mag's investment was wiped out.  She was depressed.   Then she went ot see her tax advisor.

ADJUSTED BASIS OF MAG SCRATCH'S FLORIDA CONDO

The adjusted basis of Mag's condo is $175,380 original basis minus $12,549 of depreciation she claimed on her income tax returns in 2007 and 2008.  Thus, the adjusted basis comes to $162,831

CAPITAL LOSS

The fair market value of the condo will be specified on the 1099-C that the bank sends to Mag.  It will probably specify a fair market value was $30,000 -- the amount the bank got with it resold the house.   Do you think the bank would admit selling the condo for less than fair market value?  I think not.  So the 1099-C will give us a fair market value of $30,000.  We know from the above calculation that the condo's adjusted basis if $162,831.  Therefore, Mag has a capital loss equal to the $30,000  amount realized, or "sales price," minus the adjusted basis of $162,831.  The capital loss is $132,831.  If this were Mag's personal residence or vacation home, she could NOT claim the capital loss AT ALL on her income tax return.  However, since this is a rental property, she has a long-term capital loss of $132,831  that counts.  Unfortunately, like all capital losses, Congress only lets you claim $3,000 of it in any year. The rest of the $132,831 has to be  written of yearly at $3,000 per year.  So Mag can write off $3,000 every year until her $132,831 is used up -- if she lives that long.

CANCELLATION OF DEBT INCOME

Mag's initial mortgage amount on the condo was the $175,380 purchase price less the $30,000 down payment. This comes to $145,380.  Since that time, she has only managed to pay interest on the mortgage, so the balance is still $145,380.  Her cancellation of debt income is therefore $145,380 minus the fair market value of $30,000: $115,380.  Unlike her capital loss, this cancellation of debt income needs to be included in her income tax return right away.  In reality she has a $132,831 loss and a $115,380 income -- which altogether is a net loss.  But since all but $3,000 the loss needs to be spread out to future years and ALL the cancellation-of-debt income needs to be recognized immediately, Mag Scratch, who has worked and scrimped and saved at near poverty levels for her whole life, is now going to have a 2010 "Foreclosure Windfall Profit" of $112,380 ($115380 minus $3,000 capital loss write-off) and an extra income tax bill of over $20,000.  What a way for Congress to kick her while she's down!!   She folded her arms and looked sullen at the conclusion of this calculation -- and rightly so.

EXCEPTIONS THAT COULD SAVE MAG SCRATCH

Even after President Bush's signature of the Mortgage Forgiveness Debt Relief Act of 2007, the exceptions to the Foreclosure Windfall Profits Tax are limited.  For details on exceptions, see our earlier article. Let's run through the big ones:

QUALIFIED PERSONAL RESIDENCE DEBT: Nope, this is not Mag's personal residence.

QUALIFIED BUSINESS PROPERTY DEBT: Nope, rental is NOT A BUSINESS to the Congress.  If Mag were running a retail antique shop out of house, she would have an exception -- but there is no exception for a rental property.

BANKRUPTCY - Nope, Mag didn't file for bankruptcy.

NON-RECOURSE DEBT - Nope, Mag had a regular mortgage on a regular house or condo.  Even though the bank agreed, as part of the "deed in lieu of foreclosure" process, to NOT pursue her for any unpaid balance over and above what resale of the condo brings -- the the original underlying mortgage was a recourse debt.

INSOLVENCY -- Ah!  Here's a good one.  If at the time of the foreclosure Mag's debts exceed the fair market value of her assets, her cancellation of debt income is non-taxable to the extent of the excess of debts over assets.  So let's add up Mag's assets and liabilities:

Assets:
Condo        $30,000
Home         285,000
Savings        50,000
Car              11,500
TOTAL ASSETS: $376,500

Liabilities:
Home mortgage $57,000
Condo mortgage $145380
Credit cards  None
TOTAL LIABILITIES:  $202,380

Mag's assets exceed her liabilities.  Mag is therefore not insolvent.  She does not qualify for the insolvency exception.

Mag has suffered an actual loss. The net effect of all of the above is that Mag lost her $30,000 plus all the worry and cash she poured into the place while she had a negative cash flow.  In 2010 tax terms, she lost the $30,000 down payment less the depreciation she had claimed on her rental Schedule E. ($30,000 down payment minus $12,549  of depreciation equals the net loss of  $17,451, just as $132,831 capital loss less $115,380 forgiveness-of-debt-income equals the same net loss of $17,451.)   In an emotional sense, she also lost her hard work and emotional investment in her retirement planning. She lost her whole retirement strategy. To add insult to injury, Congress is going to tell Mag that she MADE $112,380 extra in 2010 and she therefore OWES an extra income tax amount of more than $20,000, plus extra state income taxes.  Because of Congress' Alice-in-Wonderland tax rules, Mag will not be retiring any time soon.  All of this rubbish is courtesy of Mag's Congressman Chris Van Hollen and Senators Barbara Mikulski and Ben Cardin -- and all the other clowns of Capitol Hill.  You get what you vote for, friends!!!

Please note: These crazy tax laws were made by the clowns we have sent to represent us in the Senate and House of Representatives.  I say that it is time to send Mr. Smith to Washington with a crowbar.   VOTE FOR NO INCUMBENTS IN 2010 PLEASE!!!  Vote wisely on November 2!!!!


PS -- If you've been reading carefully, you have a question.  If the bank foreclosed in 2009, why will Mag include this in her 2010 tax return?  Answer: the bank didn't resell the condo until 2010.  Until they know how much money they will get from the condo sale, they don't know how much unpaid mortgage will have to be forgiven.  Also, they don't know the fair market value of the property so that a capital gain or loss can be computed.  Therefore, the bank will wait until tax year 2010 to send out the 1099-C and it is in 2010 that Mag will report the capital loss and cancellation of debt income.


CONTACT EMAIL ADDRESSES FOR US SENATORS

JC Leahy, MA Accounting
Maximum Legal Refund (tm)
JC Leahy and Company, LLC
Silver Spring, Maryland

2 comments:

Anonymous said...

Evelyn, Milford, DE:
My house is not on the foreclosure list right now, but if we have much more inflation it might be then. Thanks for the information, for just reading it made me more aware of the problem.

Anonymous said...

Bertha, Rockville, MD
Wow..that wedding looked really fun.I have never seen you look that good. The bride was very pretty. I haven't had time to read jaitoday for a while. What information! I am hoping people are reading this vital info...The foreclosure part is completely an eye opener. I had no idea. Now I know who I can refer someone to if they have issues with this..YOU!!!