Extension of Mortgage Debt Relief and Debt Cancellation: Options If Your Mortgage Is Still Underwater
The Mortgage Forgiveness Debt Relief Act survived the fiscal cliff when it was given a one year extension through 2013. Homeowners who sell their primary residence in a short sale or lose their home to foreclosure will not have the added insult to injury of losing their home and then having to pay taxes on the loss up to $2 million ($1 million if married filing separately). Granted, neither of these options is ideal—no one wants to voluntarily take a loss and harm their credit score for years—but there are circumstances when a short sale or foreclosure is the right strategic financial move, even for high income earners. At least it is still an option to explore.
Many homeowners whose mortgages are underwater and want to either move or simply move on are between a rock and a hard place. In my home town of Park City, Utah, I often talk with retirees from all over the country who are now long distance landlords renting out their primary residences in other states because they just wanted to retire and ski. Many of them wish they had done a short sale or a strategic foreclosure because now they are stuck with a negative cash flow, a long-distance hassle, and no possibility of debt forgiveness since the home is now a rental. Of course, getting a short sale approved by the bank isn’t a guarantee, so a homeowner who unsuccessfully attempts one could be worse off than when they started (if they stopped making their payments).
At least the mortgage debt relief provision is still on the books, but this provision may have a limited shelf life, so if you are considering taking advantage of this provision, do your analysis and make your move early this year.
Here are some options still available to you in 2013. You can:
Ride it out –Choose not to take any action. Sometimes waiting may be your best option especially if you don’t have a pressing need to relocate. Home prices recently jumped 3.6% from a year ago, the largest year-over-year rise we’ve seen in over two years. If that trend continues, staying put might be the right decision. If your home value is $250k and prices jump up by 3.6% a year for the next five years, your home value would be close to $300k – a $50k gain. Depending on how the market does, you could be in the black sooner than later.
This option is best for people who don’t have an urgent and immediate need to move – in other words, have the luxury to ride it out. Your local real estate professional has access to regional housing sale trend data which would be helpful in making your decision.
Refinance under the HARP refinance program – Stay put and try to reduce your costs. Homeowners who don’t qualify for a traditional refinancing loan may still qualify for the HARP refinance program specifically for mortgage holders that are underwater but have not missed a payment. If your loan is owned or guaranteed by Fannie Mae or Freddie Mac and your debt to equity value is greater than 80%, you may qualify. For more information, click here.
Sell your property through a short sale – Since some or all of the forgiven debt on a primary residence sold in 2013 may be excluded from income, this option might be viable if you want or need to move. It could cost you more in the long run to ride it out than to bite the bullet with a short sale. For example, if you end up having to rent your home and move to another location like my friends in Park City, the rental is no longer your primary residence and you lose the opportunity to exclude forgiven debt from your income. If you end up having to do a short sale later, it could be very costly. The forgiven loss amount is added to your ordinary income. For example, a couple with taxable income of $200k who had a loss of $100k would bump up to the 33% federal tax bracket and owe over $30k more in federal taxes.
A short sale might be a good option for someone who won’t be hurt by the credit score hit – a short sale or foreclosure will give you a drop in your credit score of 85 – 160 points according to FICO. If you don’t need to make any major purchases on credit for the next few years, this drop may not affect you. However, if you plan on buying that’s a different story, but don’t cut off your nose to spite your face and stay in a property that is draining you JUST so you don’t hurt your credit rating.
There is no guarantee that a bank will approve a short sale, but according to realtors who specialize in short sales having a financial hardship makes a difference with the lenders. If your income has dropped or you have some other compelling financial hardship, that may help you secure a short sale. Another factor is whether you simply have a first mortgage or the added complications of a second. When there is only one loan on the property, or the same bank holds both the first and the second, the bank may be more likely to grant the short sale. Neither of these reasons will guarantee your short sale is approved, but your chances may be better.
Give the property back to the bank with a deed in lieu of foreclosure – For those who don’t qualify for a short sale, a strategic foreclosure in 2013 may still be an option with the extension of the Mortgage Forgiveness Debt Relief Act. Be careful though, the IRS may not require you to pay income taxes on the debt but the bank may be able to get a deficiency judgment for the difference. To find out if your state is a “recourse” state and allows deficiency judgments, consult an attorney or your local realtor. For a list of recourse and non-recourse states, click here.
Of course a short sale or foreclosure is only something to consider when you are between a rock and a hard place, but with the relief offered by the Mortgage Forgiveness Debt Relief Act extended for only one more year, the time to act may be now. It’s best to talk with your tax professional, financial planner, and local real estate agent to analyze your options before making any final decisions.
Nancy L. Anderson, CFP ® is a Resident Financial Planner at Financial Finesse, the leading provider of unbiased financial education for employers nationwide, delivered by on-staff Certified Financial Planner™ professionals.