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.
