Money Law Blog

Homeowners in DC, VA and MD seeking loan modifications to save the family home may see improvements in the currently messy process if a group of state attorney generals and federal officials are successful in on-going settlement talks with major US banks.

"What we're really trying to do is change a dysfunctional system," Iowa Attorney General Tom Miller, the point man for a 50-state effort, told the Washington Post in a March news article. "We really want to try and change all that."

Homeowners who have asked mortgage lenders (or more specifically, the mortgage servicing department of banks who administer the loans on behalf of bond investors) know very well the many and outrageous modification abuses including:

• Losing homeowner's modification applications and causing them to have to submit the documents numerous times, or giving up altogether.
• Leaving homeowners in the dark for months or years as to the status of the applications.
• "Dual tracking" homeowners so that while the modification is pending the loan is also put on track for a foreclosure catching the homeowner unaware as he or she is awaiting a decision.
• Rejections of the modification application without a statement of the reason(s).
• Fraudulent statements from mortgage servicers misstating the amount owed by employees who swear to, but have not actually checked, the lender's records.
• Employees at the mortgage servicing departments telling homeowners to make a reduced payment pending the modification, then holding the homeowner in default for thousands of dollars later when the modification is denied. It's either pay up all at once or go to foreclosure.

Many of the mortgage modification abuses have been written about in this blog based on the experiences of the clients of our bankruptcy law firm.

The government's initial 27-page proposal provides for some important reforms:

• A time-line for decisions.
• Guidelines for determinations, and possibly mortgage principal reductions.
• A web-based portal for homeowners to track the application in real time.
• A ban on "dual tracking."

Most importantly, the proposal provides for penalties for the mortgage servicers. For this writer, that would be the single most important reform. At present, lenders operate with impunity. There is no law that clearly holds mortgage servicers accountable. Penalties would put teeth into the reforms and, it's hoped, put an end to the abuses.

It feels like another kick in the teeth: You lose a home or rental property in a foreclosure or short sale, get a Form 1099-C from the mortgage company, and now you have to pay income taxes on it, too? Like a lot of things in the law, it depends.

It's a curious, but absolutely-settled principle of tax law, that a debt that is forgiven by a lender becomes taxable income to the borrower. Basically the accounting works like this: When you took out the loan it's not considered income because you have an obligation to pay it back. When, however, that obligation is removed, you become richer by the amount of debt that you will not have to pay, and the tax law says that must be recognized and you must pay income taxes on it.

Unfair, you may say, but it's the law. In late 2007, federal lawmakers decided to give SOME relief to taxpayers losing personal residences and changed the law so that the resulting income could be excluded from income tax, if the forgiveness (also known as "cancellation in indebtedness" and
"cancellation of debt" ("COD") income) meets key requirements:

1. The mortgage debt was for a principal residence (that is, the property was the taxpayer's "home" under the law) and,
2. The mortgage debt was the original loan used to purchase the home, or, if the loan was a refinance of the original loan, the proceeds from the refinance were used to make improvements to that property.

Note that the author of this blog emphasizes the term "some" because there is a lot of misinformation out there, probably propagated by commission-hungry, short-sale realtors, that there is a blanket exclusion from COD income for all primary residence mortgage debt forgiven in short sales (or foreclosures, which, for the tax law, are functionally the same).

Nope, doesn't work that way. If the loan was a refinance or second mortgage where part of the proceeds was used to pay off car loans, credit cards, take vacations, etc., those proceeds will NOT qualify for income tax exclusion under the tax law.

Your tax preparer will need to fill out Form 982 and see if the COD income reported to IRS on the Form 1099-C can be excluded under the exceptions available. Our DC-based tax and bankruptcy law firm has prepared an guide to the tax effects of foreclosures and short sales explaining the issue.

One of the most important exceptions is the "insolvency" exclusion. You can exclude the COD income from taxable income to the extent your net worth calculation shows you are insolvent.

If you use that exclusion, it's a good idea to keep the documents you use to calculate your net worth. Generally, the government has three years to audit your tax return. Values of assets and debt balances can change significantly in the interim and determining them years later will be impossible.

Remember, finally, that a discharge in bankruptcy avoids the tax issue entirely. So, if you're not sure the lender will forgive the debt after the foreclosure, or if you know the debt will be forgiven but are unsure or worry about the tax consequences, you may want to consider that option.