How to Handle Not Knowing – The Mortgage Debt Relief Act

The bad news:   It is nearly two months into 2014 and Congress has not extended the Mortgage Debt Relief Act. (MDRA)

The good news:   There are still more than 10 months remaining before any taxes may be due for short selling homeowners who close in 2014.

If you were a betting person:    One of our Virginia Congressmen, Scott Rigell, expects that the MDRA will be extended.  Bills are meandering through committees that could restore the exemption before year’s end from taxability of the “phantom income” from debt that is forgiven by mortgage lenders.    Congressman Rigell’s office works hard to stay abreast of lending industry developments and often acts as a resource for downtrodden homeowners who can’t get a fair shake from their mortgage lenders.

Is there a Plan B?    Attorney Hunter Hanger often recommends to his clients that they consult with their CPA or tax advisor on using the “IRS Insolvency Clause” to help reduce or eliminate tax liability on forgiven debt.  While applying the IRS definition of insolvency may not rescue every strategic defaulter or investment property short seller, it could be easier than expected for primary residence short sellers to use as a safety net.  The formula for relief is based on whether the seller’s total of debts and liabilities exceeds their assets.   If your home is “upside down”, this generally means for the average American that there are not a lot of assets!

The Irony:     Some homeowners who were unable to complete their short sales by the end of 2013 and some homeowners who are right on the edge of no longer being able to consider the home they are short selling as a “primary residence”, e.g., they have rented it out for nearly 3 consecutive years, are taking a second look at deliberately electing to treat their home as an investment property.    In some cases it may actually have tax advantages!

The Bottom Line:      If you considering selling or walking away from a burdensome real estate property in 2014, you should consult with you tax expert and a legal expert early!    The tax and legal consequences are currently in a state of upheaval.     You can:  (1)  wait and see if the extension of the MDRA will bail you out from having to pay taxes on phantom income;  (2)  use advanced planning to evaluate or manipulate your potential insolvency under IRS guidelines;  or (3) see if converting your primary residence to investment property status may help you.   There may be a seasoning element involved in establishing insolvency or changing status from primary residence to investment property and this may affect the timing of putting your home on the market.   Alternatively, you may want to market the home immediately but market it as a Lease with Option to Purchase or other type of sale that defers final deeding of the title out of your name until after your seasoning requirements are met.   Consult an attorney who specializes in alternative conveyance plans or “creative financing”.

Worst Case Scenario:   If there is a perfect storm of tax disaster for you, i.e.,  the MDRA is not extended, you don’t qualify under IRS guidelines as insolvent, and there is no legal way to elect to treat your home as anything other than a primary residence, you can still help your cause in two ways:    (1)  Try to accumulate cash.   Cash reserves, especially if held for you by a relative who is not obligated on the mortgage or the tax debt, can help immensely to negotiate discounts and get you “closure” sooner rather than later.   Tax debts can also go away over a period of time.  But it is a long period of time and it is “open season” on your bank accounts, certain other assets, and your credit rating.   (2)  Never give up hope.   With planning and a proactive attitude you may have to endure some ongoing hardship, but you still have choices on which hardship, the severity of the consequences, and how long it takes to recover.    After considering all their alternatives, e.g., foreclosure, bankruptcy, deed in lieu of foreclosure, selling the home with creative financing, and SHORT SALE EVEN WITH TAX LIABILITY FOR FORGIVEN DEBT, 99% of all homeowners still fare far better in Short Sale than in Foreclosure!

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