By MARILYN KALFUS / THE ORANGE COUNTY REGISTER
October 10, 2012
Homeowners down on their luck and considering a short sale may now have to think about placing another bet.A law exempting some from having to pay taxes on debt forgiven by the bank – the Mortgage Forgiveness Debt Relief Act and Debt Cancellation — is set to expire at the end of this year.
There’s optimism in the real estate industry that the act could be extended, but there’s no guarantee, especially in a post-election lame-duck session. Others say the act would cost too much to extend in light of big budget deficits.
Either way, homeowners contemplating short sales as a way to get out of debt may want to seek financial advice.
“There’s a lot of confusion out there,” says Alex Creel, chief lobbyist for the California Association of Realtors. “A lot of people aren’t going to be tuned in to the legal technicalities. It gets really complicated.
“If you’ve got a lot of potential debt forgiveness in the mix and there’s going to be a large tax consequence,” he says, “you might want to see an accountant and spend some time thinking that through.”In California, many distressed homeowners who think the act will help them avoid paying some taxes may find it doesn’t, or that they don’t even need it. But many will, a tax expert says.More on that in a minute.
Short sales have been playing a big part in the Orange County housing market in recent years, far eclipsing foreclosures. In August, 29% of distressed local listings were foreclosures being sold by banks; while 71% were short sales, according to an analysis by Steve Thomas, who regularly analyzes residential real estate sales in Orange County, “The expected market time (for short sales) is only two weeks and continues to be the hottest segment of the housing market,” he says.
How the debt relief act works
Most people know that in a short sale, the house is sold for less than the balance remaining on the mortgage, if the lender agrees.
When a bank lets a homeowner transact a short sale — or forecloses or modifies a home loan — the forgiven amount has traditionally been considered “income” to the homeowner and is reported to the Internal Revenue Service.
The Mortgage Forgiveness Debt Relief Act of 2007 exempts homeowners from having to pay tax on up to $2 million in qualified forgiven debt. Only cancelled debt used to buy, build or substantially improve a principal residence or refinance debt incurred for those purposes qualifies for the exclusion, the IRS says.
The National Association of Realtors and other proponents of the act have said that without it, the short sale market would largely freeze up, threatening the recovery and the economy, while troubled homeowners deciding to brave a short sale could again be mired in financial woes — tax payments they can’t afford.
Now for the California twist. In many cases in this state, debt forgiven on certain types of loans is already exempt from being taxed. California is a “non-recourse loan” state when it comes to purchase money mortgages. That means when a bank forecloses on a property or short sale occurs, the lender is prohibited from pursuing the borrower for any unpaid balance. Under these circumstances, tax experts say, the homeowner typically does not pay taxes on the unpaid balance, which is not considered income.
For those who have refinanced, however, the “non-recourse” status often goes out the window. Now, they most likely have a “recourse loan.” But in these cases, the debt relief act may help them avoid paying taxes on the forgiven debt, explains Bradford L. Hall, a certified public accountant and managing director of Hall & Company CPAs, an Irvine firm.
Those who have refinanced (or taken cash out) to make improvements to their home – and have the documentation to prove it – would be covered by the act, he says. However, if they took the cash and spent it in other ways, the act would not apply.
“Non-recourse loans do not have a tax liability,” Brett Chapell, business development director at Short Sale Tax Pro in Temecula, told real estate agents at the California Association of Realtors convention in Anaheim last week. “The greatest thing about the Mortgage Forgiveness Debt Relief Act is it does cover recourse loans.
“That’s a big deal,” Chappell said. “That accounts for a lot of people.”
California’s mortgage debt forgiveness law, which has lower limits – up to $800,000 — also is due to sunset at the end of the year. Creel says the state Legislature is expected to extend the state law to conform with a federal extension, which he is optimistic will occur at some point. He notes there’s bipartisan support to keep the tax exemption going. The law also could be given a green light retroactively next year.“I think there is still a large (number) of homes out there that will be prime inventory for short sales, and the feds have to realize that at some level and have to realize the negative impact (of losing the debt relief act) would be very great,” he says.
Hall is among those who do not think an extension is likely.“
If I was betting, I would bet it’s not going to be extended,” says Hall. He thinks the $2.7 billion it would cost to extend it for two more years – as reported by the Congressional Budget Office — won’t fly in the face of fiscal deficits.
Others think that allowing the act to expire would help the housing industry.Dennis Smith, a mortgage broker in Huntington Beach, thinks the pending expiration has created a greater sense of urgency among homeowners contemplating strategic defaults, voluntary foreclosures and short sales.
“I can’t see any program that encourages people to default on loans — costing lenders billions which are passed on to new borrowers with higher fees, insurance rate (and) tighter credit requirements — is positive for the housing industry as a whole or in part,” says Smith, co-owner of Stratis Financial, a mortgage company.
Tax experts note that there also are other laws on the books allowing exemptions for debt issues, such as insolvency.
“There are no cookie-cutter solutions,” Chappell says. “Everybody’s situation is different and everybody’s tax scenario is different.”But, he told the Realtors gathered at the convention in Anaheim, “This stuff is complicated … The IRS is looking at these returns very closely.”