Loan Modifications and Short Sales: The Hidden Costs

Bankruptcy is often used as a method of foreclosure prevention, especially in Georgia where the foreclosure process is expedited compared to other states.  However, over the last few years, more lenders have been willing to negotiate the terms of mortgage loans through loan modifications, in order to make it more affordable for the homeowners.  In addition, more lenders have been willing to compromise their balances in order to accommodate the “short sale” of a property which the homeowner is unwilling or unable to afford.  In the instance of a short sale, the lender will reduce the balance on the loan in order to facilitate the sale of the property to a third party.  The lender receives all of the proceeds of the sale, and agrees not to seek payment of the remaining balance from the borrower.

Normally there would be tax consequences from the lender’s reduction of the outstanding balance, whether through a loan modification or short sale.  This is because the “forgiveness” or “cancellation” of debt is considered income under the Internal Revenue Code.  So if a mortgage company modified the loan and reduced the principal balance by $30,000, the borrower could be considered to have “earned” that $30,000, and would have to pay income taxes on it.  Likewise, if the lender agreed to a short sale where it reduced the mortgage balance by $30,000, the borrower could have to pay taxes on it.  But from 2007 until December 31, 2013, Congress had exempted these transactions from being taxable, provided that the mortgage loan at issue was secured by the borrower’s residence.  The exemption from taxation did not apply to commercial loans.  So borrowers were able to obtain the benefit of a loan modification or short sale without the taxable consequences.  Unfortunately, the exemption expired at the end of 2013, which means that homeowners who are in the process of negotiating a loan modification or short sale may face significant tax liability later on down the road.[i]

To compound matters, some mortgage companies have begun “writing off” second mortgages on their own, without the request of the borrowers.  This is more common in situations where the second mortgage is in default, and the home is underwater.  Usually this is done by one of the five banks (Bank of America, Citimortgage, Ally/GMAC, Wells Fargo and Chase) that had entered into a settlement with the federal government regarding faulty loan and foreclosure procedures, whereby they agreed to write down a percentage of their residential mortgage debt.  Once again, while the elimination or reduction of the mortgage debt was designed to assist the homeowners in keeping their homes, the primary beneficiaries are the banks who are able to demonstrate compliance with their settlement obligations.  So while the borrower may no longer have a second mortgage, they have now generated a significant income tax bill based upon the amount of the second mortgage that was “forgiven”.

If you are a homeowner who is considering a short sale, or the surrender of a residence that you can no longer afford, you may wish to consult a bankruptcy attorney.  If a residence is surrendered to a lender in a bankruptcy proceeding, then any debt owing is “discharged”.  Unlike a situation where the lender voluntarily agrees to reduce or cancel its debt, a bankruptcy discharge does not create a taxable event.  So following the filing of a bankruptcy, the lender is entitled to sell the distressed property, and will probably receive significantly less than what is owed.  But due to the fact that its debt was discharged, the lender cannot “forgive” the debt and potentially leave the borrower with a hefty income tax bill.  Since many local bankruptcy attorneys offer a free consultation, it certainly would make sense to understand the tax implications and bankruptcy options before agreeing to a short sale or loan modification with a substantial reduction in principal balance.

[i] Congress does have the ability to retroactively restore the exemption, but given the current state of gridlock, it is uncertain as to whether the exemption will be restored in the near future.