No Replacement for the Mortgage Debt Relief Act yet. Now what?
Ask any real estate professional who handles short sales what is their most pressing concern, and chances are they will point to the fact that as of December 31, the Mortgage Debt Relief Act of 2007 is set to expire. As of today, there is no serious replacement or extension on the table. This has many agents greatly concerned about the future of short sales, with some speculating that it may be the end of the run. I disagree wholeheartedly, and here is why:
First, let’s recap what the Mortgage Debt Relief Act of 2007 does. The Act provides for protection for some sellers regarding the tax liabilities from the 1099-C received when a lender forgives their debt. In plain English, when a lender waives deficiency, that amount is “Forgiven” debt, and a 1099-C is issued. According to IRS rules, this forgiven debt is to be considered as “income,” and therefore subject to be taxed. While wholly unfair to the seller, since this is not actually income received, it is, nonetheless, law. The Act protected those who are selling primary residences, and usually applies only to first liens, credit lines used for purchase money or home improvement. In other words, it was a major selling point in a seller’s consideration of how to address their selling situation, and one that made a short sale attractive over a Deed in Lieu or a foreclosure.
Many agents fear that without the protection of the Act, short sales will cease to be an attractive option for homeowners, but I believe that this is unwarranted. The main reason for this is that, at least for me, about 40% of short sales do not qualify for the protection of the Act right now, and yet; sellers still feel that the benefits outweigh the risks. Further, new GSE (Fannie/Freddie/HUD) guidelines are making full deficiency waivers more of a certainty than in the past. Moreover, it is extremely rare that sellers not protected by the Act actually owe a tax liability. Let’s take a look at these three major points in depth:
Protected vs. Unprotected Property
As of now, even with the Act in force, only primary residences are covered. This means that a large percentage of sales are not covered. There are certainly many sellers who are liquidating investment properties and second homes. The benefits afforded to these sellers are manifold, including:
- The chance for a full deficiency waiver
- Avoidance of a foreclosure on credit
- Psychological benefit: Taking action and selling vs. letting bank foreclose
Tax Liability vs. Deficiency
It is important for agents to understand this difference, because confusion of these terms is commonplace.
Deficiency: The difference between what the lender nets on sale versus what the borrower owes. This difference will be reflected on the 1099-C issued by the lender.
Tax Liability: This is the amount that may be considered forgiven debt, and therefore, income, based on current IRS rules. This is what is currently covered in some cases under the Mortgage Debt Relief Act.
In other words, Deficiency is what you owe the bank, and Tax liability is what you owe the IRS, and the two are not mutually exclusive.
As of November 1, 2012, the major Government Servicing Entities (GSE’s) such as Fannie Mae, Freddie Mac, and HUD, have amended their guidelines to include a full deficiency waiver for most sellers. This is an important development, because the deficiency waiver preserves the most valuable benefit of a short sale for the sellers. The ability to complete a short sale and be virtually guaranteed a full release on the first lien is a major step in the direction of solidifying the short sales place in the market. In most cases, a full deficiency waiver means more to a seller than tax liability protection.
This section is not intended to give legal advice, and I am not an attorney. It is my position on ALL short sales, that the seller has competent legal representation. I work very closely with attorneys in the short sale process, and here are the reasons why most attorneys and CPA’s will agree with my assessment on tax liability;
On a short sale not covered under the Act, the seller’s lender will issue a 1099-C-forgiveness of debt. This can be counteracted in several ways. The most popular are:
- IRS Form 980. This is the insolvency test. In many cases, regardless of income or assets, a sellers paper debt meets or exceed their assets. In such a case, the seller may be legally insolvent, thus exempting them from tax liability. In other words, all debts, including all mortgages (which are most likely underwater) count towards liabilities. This is especially helpful for sellers with more than one property. In all cases I have seen where sellers, even showing significant assets, once they showed their liabilities via this form, the insolvency test was passed and they were not liable for taxes owed. To find out if your seller qualifies, always refer to a competent attorney or CPA.
- Loss on Sale. This is another way that a good CPA can offset tax liability. The 1099 income will be reported, but the loss on the sale should counteract this income. The loss will include the difference between selling price and purchase price, plus any down payment the seller put into the transaction.
While it is my personal belief that the Act will be extended or replaced sometime in 2013, the expiration of the Act is no cause for quitting short sales. In fact, the new GSE guidelines may make short sales even more attractive to sellers. To protect yourselves and your sellers, partner up with a good attorney and CPA and let them counsel your clients as to their tax options, and take that short sale listing!
Mortgage Debt relief Act Information:
Illinois Real Estate and Tax attorney endorsed by SSP and Joseph Alfe:
Gregory A. Braun, McCormick, Braun Friman LLC