Mortgage Debt Forgiveness? The IRS Will Want Its Share

(MCall.com):

For homeowners around the country who are seriously delinquent on their mortgages and hoping for relief, the IRS has bad news: If your lender agrees to modify your loan and forgive any part of your debt, you could owe federal income taxes on the amount forgiven.

Think of it as the tax code’s ”kick-em-while-they’re-down” rule. When personal debts are canceled by a creditor, the amount forgiven is treated as ordinary income under the Internal Revenue Code unless the taxpayer is insolvent or bankrupt. Worse yet, the lender is required by law to report the amount canceled to the IRS.

Ouch! This is especially bad news for the growing numbers of subprime, or credit-impaired, borrowers charged a higher rate of interest, who find themselves ”upside down” in the current real estate market: They owe more on their mortgage than the value of their house, thanks to noxious combinations of zero down payments, declining property values, and hefty payment increases they can’t afford.

Diane Thompson, an attorney with the Land of Lincoln Legal Assistance Foundation in East St. Louis , Mo. , tells of one client who learned about the tax code’s Catch-22 the hard way. After the homeowner negotiated a loan modification agreement with her lender, she assumed that she was done with the matter. But a year later, the IRS came after her demanding a large tax payment on the amount the lender forgave — a tax bill that was equal to her annual income. Her lender had dutifully submitted a Form 1099-C to the IRS, alerting the agency to the woman’s extra ”income” from the loan modification.

The homeowner never had actually received that income in any tangible way; she couldn’t deposit it in her bank account. But under federal law, the IRS had every right to come after her for unpaid taxes.

Similar situations are likely to pop up around the country in the coming year as lenders bend over backward to modify thousands of troubled loans before they go to foreclosure. Proposed new, bipartisan legislation on Capitol Hill could soften some of the impact on financially stressed homeowners, however. The Mortgage Cancellation Tax Relief Act of 2007 (HR 1876) would amend the tax code to exclude debt forgiveness on principal home mortgages from treatment as income.

Introduced in mid-April by Reps. Robert E. Andrews, D-N.J., and Ron Lewis, R-Ky., the bill would allow lenders to restructure delinquent mortgages without worrying about income-tax hand grenades hitting their borrowers the following year. The legislation potentially could assist many other homeowners in financial trouble who negotiate pre-foreclosure ‘’short sales,” deeds-in-lieu-of-foreclosure or whose foreclosure proceeds are insufficient to pay off their mortgage debt.

Short sales are increasingly commonplace. Say you are seriously behind on your mortgage payments and a loan modification or rate reduction won’t solve the problem because you’ve just lost your job. As an alternative to foreclosure, your lender might suggest a quick sale of the house, often to an investor who’ll buy it as-is at a discounted price. If the short sale proceeds are $10,000 less than the outstanding mortgage balance, and your lender agrees to forgive that amount, the Andrews-Lewis bill would allow you to obtain that relief tax-free.

Under current law, by contrast, your lender would be required to report the $10,000 in phantom income to the IRS. Ditto if you went to foreclosure and the sale proceeds yielded $10,000 — or $50,000 — less than the outstanding debt owed to the lender.

Proponents of the debt-relief reform bill argue that short sales, mortgage delinquencies and foreclosures are painful situations for most homeowners, and there’s no public policy purpose served by smacking them with tax penalties that make things even worse. In the case of below-market short sales, for example, most homeowners have already suffered sizable capital losses that are not tax-deductible.

They’ve lost thousands of dollars in equity.

Why pile on?

The outlook for the bill: It’s currently before the House Ways and Means Committee, Congress’ primary tax legislative body. Since most of the majority Democratic housing and banking committee leaders have called upon banks and mortgage companies to work out solutions to keep troubled homeowners out of foreclosure, a bipartisan tax fairness bill like this one should have a reasonable chance of passage.

Few lenders willing to make mortgage modifications, survey says

Carolyn Said, Chronicle Staff Writer

Thursday, October 11, 2007

 

Mortgage lenders rarely help homeowners struggling with rapidly increasing adjustable mortgages, according to a survey of 33 California housing counseling agencies released on Wednesday.

Only one agency responding to the survey said that loan modification – adjusting a mortgage’s terms to make it more affordable – is among the most common outcomes for its clients.

Instead, foreclosures were the most common outcome for agency clients overall, according to the survey by the California Reinvestment Coalition, a statewide alliance that promotes access to credit. The second-most-common result was a short sale, selling a home for less than is owed on the mortgage.

In recent months, attention has focused on loan modifications as one solution to the subprime loan crisis, in which about 2 million homeowners nationwide have mortgage payments that are due to skyrocket within the next two years.

Politicians, banking regulators and consumer advocates have urged lenders to avert foreclosures through loan modifications. Banks in turn have publicly embraced the concept but have not provided statistics to show how common loan modification actually is.

“Lenders are all saying the right things: ‘It makes no sense for us to foreclose, we don’t want to foreclose, we lose money when we foreclose, we want to keep borrowers in their homes, we know we have to do workouts and loan modifications,’ ” said Kevin Stein, associate director of the coalition.

“The most striking thing that came out of this (study) is that there is a huge chasm between what the lenders are stating, which very well may be their policies, and what’s happening on the ground. That clearly works to the detriment of homeowners and their communities.”

The San Francisco coalition surveyed 33 of the state’s 80 mortgage counseling agencies. The surveyed agencies had counseled about 9,800 consumers in August.

A study from Moody’s Investors Service released in September also showed that loan modifications are rare. After looking at 16 loan servicers that handle $950 billion of subprime mortgages – accounting for about 80 percent of the market – Moody’s said only 1 percent of people with loan rates that reset higher in January, April and July received help from their lenders to make their payments more affordable.

Katrina Vizinau, senior homeownership counselor at Community Housing Development Group of North Richmond – one of the surveyed agencies – sees about 50 clients a month with mortgage problems. She agreed that loan modifications are rare. It takes a frustratingly long time to get an answer from lenders, she added.

“When they do (offer a loan modification) the terms are unrealistic for the homeowners; the payments would be a hardship for them,” she said.

Often lenders refuse to discuss loan modifications until a consumer has missed payments, Vizinau said. Because missed payments hurt a consumer’s credit, that creates a catch-22.

Paul Howard, who has an adjustable-rate mortgage on his Sacramento home, said seeking a loan modification was frustrating.

Howard, who works in Berkeley’s human resources department, bought his house for $274,000 with 100 percent financing in April 2005. The in-law who arranged his adjustable mortgage told him it would stay at 5.75 percent for five years (a $1,400 monthly payment).

“I was shocked when after just two years, it adjusted,” he said. “I should probably have paid closer attention to details.”

In May the ARM rose three percentage points, adding $550 to his monthly payment. It was scheduled to continue rising every six months. Meanwhile, the house had declined in value to about $225,000, ruling out a refinance or sale for enough to pay off the mortgage.

Howard contacted his servicer, Litton Loan Servicing, in April, notifying it that he could not afford the higher payments and asking for relief. He stretched to continue covering the mortgage.

After leaving numerous voice messages and e-mails, Howard said that Litton eventually told him he did not qualify for a loan modification, although he has good credit and a relatively high income.

By this month, Howard said he was so desperate to get the company’s attention that he planned to withhold his mortgage payments, hoping it would negotiate with him.

Instead, after The Chronicle contacted Litton, it called Howard within an hour, offering to roll his interest rate back to 5.75 percent for two years and forgive his October payment.

Larry Litton Jr., president and CEO of the company his father founded, said that Litton had recently implemented a new loan modification program and it turned out Howard qualified for it. The new program extends interest-only customers’ original payment level for 24 months.

“We’re trying to do everything in our power to drive down these foreclosure levels, which are really going up in the state of California,” Litton said.

Howard initially was denied “because the loan product we had available at the time would not have given him the relief he needed,” Litton said. “Since then we have created some new modification products for borrowers. We’re trying to keep them in the houses, continue to pay, and review the financials in 24 months.”

Litton handles 300,000 mortgages totaling about $56 billion.

Litton said the company did more than 2,000 loan modifications in September, 1,500 of them for people who had already missed payments. This month it expects to modify more than 3,000 loans, he said.

The coalition is urging lenders to be “more aggressive, creative and flexible in dealing with borrowers to keep them in their homes,” Stein said. Among its recommendations: Offer loan modifications across the board; freeze interest rates; require lenders to report how many loans result in modifications, foreclosures and other outcomes; develop a procedure to sell foreclosed homes to nonprofit groups for affordable housing; and increase funding for counseling agencies.