Since October 2011 the foreclosure world in Nevada has been in upheaval, and while there are many theories as to why foreclosures stopped, why inventory dropped, and how the real estate market has changed over the past two years, what all seem to agree upon is there are tens of thousands of homeowners who are more than 90 days delinquent on their mortgage payments and at some point a foreclosure action is inevitable. Various sources have reported anywhere between 60,000 homes and 120,000 homes still in default with no pending foreclosure trustee sale on the horizon. Ultimately these homeowners will be faced with either a judicial or non-judicial foreclosure to address the default status and likely will seek legal counsel as a result. In the foreseeable future there are two issues every attorney should consider when meeting with a client about home loan default and possible legal options: taxes and deficiency.
Retention options: To Keep or Not to Keep a Home?
By now everyone in Nevada is familiar with loan modifications, but there is still a gap in understanding as to how the various tiers of the Making Home Affordable (“MHA”) program works, including the most prominent Home Affordable Modification Program (“HAMP”) and the hidden variable of “who” actually owns the loan which dictates which programs a loan could be eligible. (Most servicers at present offer in internal modification that mimics one of the MHA programs if the homeowner is not eligible for HAMP) Some provisions of MHA allow for principal reduction, but it depends on who the investor is and NPV test results. It is still rare for principal reduction to be offered, but it occurs more frequently now than it has in the past as a result of the National Mortgage Settlement.
The servicers who agree to participate in HAMP are required to send out loss mitigation packages with HAMP request documents whenever a loan is in default, and now with the Homeowner Bill of Rights in effect in Nevada, at least 30 days prior to initiating a foreclosure, all servicers must provide homeowners with information regarding loss mitigation options regardless of whether or not the servicer participates in HAMP/MHA. See SB 321 State of Nevada 77th Legislative Session. The real challenge will be educating homeowners to open the mail and respond to the loss mitigation packages. Homeowners receive such a litany of mail after going into default they often stop opening the mail or assume the package is yet another foreclosure scam or the 15th copy of the same letter they opened the day before.
HAMP will still be the primary loan modification program most homeowners are offered by a majority of the servicers over the next two years, especially when the parties end up in foreclosure mediation. (MHA programs expire December 31, 2015) But there are very limited situations where the loan modification makes sense financially for the homeowners in both a long and short term setting. While most HAMP modifications reduce the monthly payment for the homeowner, after the first five years, the interest rate adjusts up from the typical 2% in 1% increments per year till it caps at the market rate. As the past four years have shown, redefault rates are in high percentages before the first interest rate adjustment even occurs, which means the loan modification is simply a band aide on a hemorrhaging problem: income is down, expenses & unemployment are up and nearly all homeowners are still underwater. So long as the loan to value ratio is underwater, there is no escape hatch for a homeowner who experiences financial hardship to sell the property in satisfaction of the debt. As the monthly payments begin to go up for homeowners under the terms of the modification, if they have not been able to increase their income or reduce their expenses, inevitably they will default on the HAMP modification creating a cyclical foreclosure wheel.
As will be discussed below, if mortgage forgiveness is included in any loan modifications after December 31, 2013, there could be tax implications for homeowners who accept principal reduction if the Mortgage and Debt Relief Act (“MDRA”) is not extended. So for many, the question isn’t simply will the bank let the homeowner keep the house, but should the homeowner keep the house & at what cost when looking at the totality of the circumstances..
A short sale is not typically a retention option, but there is a provision in the MHA-HAFA program that allows a non-profit to purchase a house via short sale, and then resell the property back to the former owner, but it does not apply to mortgage loans that are owned or guaranteed by Fannie Mae or Freddie Mac, insured or guaranteed by the Veterans Administration, insured or guaranteed by the Department of Agriculture’s Rural Housing Service or the Federal Housing Administration. See MHA Supplemental Directive 12-07. The program is only allowed IF the loan is non-GSE, IF the non-profit is approved and IF the servicer AND the investor agrees to it. As of the date of publication, this author has not been able to find an example of where a short sale closed under this HAFA exception, nor could a short sale approval from a major servicer be located that doesn’t require an arms-length affidavit. Neither Freddie Mac nor Fannie Mae permit a short sale in this manner and according to their Servicing Guidelines, all short sales must be at an arms-length. There was fervor in the Nevada legislature this past year about a provision in SB 321 which would allow a homeowner to short sell without the requirement of “arms-length.” And while the enrolled bill contains a provision that Nevada state law does not require a short sale to be at arms-length, it doesn’t change the policy of the vast majority of servicers and investors to require an arms-length transaction in order to approve a short sale with a waiver of deficiency. Misrepresentations in the short sale request or failure to disclose the relationship between the buyer and seller could result in a homeowner being pursued for deficiency down the road.
Non-Retention Options: Let it Go Now or Later?
With MDRA set to expire at the end of this year and with a strong sense the act will not be extended again, many homeowners whose foreclosure won’t be completed until 2014 or who don’t close their short sales till 2014 are going to be shocked when they receive a 1099-C for cancellation of debt and are told by their tax advisor the cancelled debt is ordinary taxable income according to the IRS. (Since 2007, most homeowners who have walked away from their principal residence or have participated in a short sale avoided tax liability as a result of MDRA) There may be situations where the cancelled debt will not result in tax liability despite the expiration of MDRA, such as when the debt was discharged through bankruptcy or when the homeowner was insolvent just prior to the taxable event.
But it’s important for legal practitioners to understand a taxpayer is insolvent when their total debts exceed the total fair market value of all assets; assets include everything owned, e.g., car, house, condominium, furniture, life insurance policies, stocks, other investments, or pension and other retirement accounts. See IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments. Also see IRS news release IR-2008-17. Insolvency does not directly translate to liquidity and state law exemptions do not factor on an insolvency worksheet. For many union and government employed homeowners with life insurance policies and pensions, despite having measly bank accounts and exempt assets which are beyond the reach of creditors under state law, they may not be insolvent and may face tax consequences as a result of a foreclosure or short sale.
In a situation where the homeowner has assets, an analysis must be conducted by a qualified tax professional to determine if there will be any exposure to tax liability prior to the completion of foreclosure or short sale. If the homeowner is solvent and likely to incur substantial tax liability, the client should be evaluated for bankruptcy relief. In Nevada, state exemptions could allow the homeowner who is solvent on paper to retain their assets while discharging the home loan debt (if they are otherwise eligible to receive a bankruptcy discharge), and avoid tax consequences since the debt is being canceled in a title 11 bankruptcy case. If the tax analysis is not done or if the homeowner is simply unaware of the potential tax consequences, walking away from the home or agreeing to a short sale could result in financial peril. Most tax debts are non-dischargeable so by the time most homeowners find out about the ordinary income tax treatment of cancelled debt, it’s too late to use bankruptcy protection.
Lastly, there is the matter of deficiency. While a majority of the servicers trended towards waiver of deficiency in either a short sale or deed-in-lieu resolution in the peak of the foreclosure crisis, it is probable servicers will eventually shift back to non-waiver policies with regard to deficiency. There have been multiple investor suits filed for improper servicing and the MHA government incentives to waive deficiency will conclude by the end of 2015 (as well as the incentive to servicers subject to the National Mortgage Settlement) Eventually a reservation of right to pursue deficiency will be a greater incentive for servicers than to simply allow the homeowners to walk away. Any homeowner relying on trends now with regard to cancellation of debt and deficiency waiver, may in the future find themselves caught in the foreclosure wake of creditor pursuit.
Tara D. Newberry, Esq. is the Managing Partner at Connaghan Newberry Law Firm, where she practices primarily in the areas of bankruptcy and consumer protection. She has been an appointed mediator by the Supreme Court of the State of Nevada for the Foreclosure Mediation Program since its inception in 2009, and has participated in hundreds of foreclosure mediations.