Washington Real Estate Law Blog : Washington Real Estate Lawyer & Attorney : Dickson Steinacker Law Firm : WA HOA, Building & Zoning Updates

I am often asked by clients what the tax implications are should they choose to pursue a short sale or their property is the subject of a foreclosure.  Technically, and they’re right.  Debt obligations that are forgiven are usually counted as income to that individual.  For example, if you obtain a home loan for $300,000 but sell the property via the short sale process for $200,000, that $100,000 difference that you are no longer required to pay would be taxable as income under normal circumstances.  In 2007, the federal government passed the “Mortgage Forgiveness and Debt Relief Act.” 

The IRS describes it as follows:

“If you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes, depending on the circumstances. When you borrowed the money you were not required to include the loan proceeds in income because you had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount you received as loan proceeds is normally reportable as income because you no longer have an obligation to repay the lender. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.”

Cancellation of Debt is not always taxable, however.  According to the IRS there are some exceptions:

--Qualified principal residence indebtedness: This is the exception created by the Mortgage Debt Relief Act of 2007 and applies to most homeowners.

--Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.

--Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your total assets.

--Certain farm debts: If you incurred the debt directly in operation of a farm, more than half your income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, your cancelled debt is generally not considered taxable income.

--Non-recourse loans: A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income. However, it may result in other tax consequences

See Publication 4681.

The Mortgage Forgiveness Debt Relief Act of 2007 allows homeowners who have benefited from debt cancellation—usually from a short sale, deed-in-lieu of foreclosure, or foreclosure—to exclude the “income realized” from the forgiveness.  Exclusion of income resulting from a cancellation of debt means that the amount forgiven or waived from the creditor (usually a bank) is not considered income and is excluded from determining your federal income tax basis.

Going back to the example in the first paragraph, the $100,000 debt that was cancelled would be excluded from that individual’s income of that year.  In a normal year (without the Act in place), if that person made $50,000, but was forgiven $100,000 through a short sale, he or she would be required to include that sum as income for that year, making his income $150,000 and subject to the corresponding tax rate.  Because that $100,000 is excluded from his income by virtue of the Mortgage Forgiveness Debt Relief Act, his tax rate is preserved at the $50,000 level.   

The above information can be found at the following link: http://www.irs.gov/individuals/article/0,,id=179414,00.html

I would also refer you to an in-depth review of the law at http://www.homesalessandiego.com/blog/mortgage-debt-forgiveness-law/.

*Lawyers at Dickson Steinacker, PS are NOT tax specialists.  Federal income taxes are a serious matter and should be dealt with through counsel from a qualified accountant or tax attorney.  Because much of our business deals with real estate issues such as short sales, foreclosures and loan modifications, we feel it is important to be cognizant of the broader implications of debt cancellation (hence, the above blog entry).  If you are in need of more detailed/specific guidance for your tax matters, we recommend contacting a tax attorney or qualified accountant.  Do not rely solely on this entry for your tax strategy.    

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In determining whether to grant a loan modification, there are generally three central factors that a lender takes into consideration: 1) the financial hardship of the borrower; 2) whether the borrower is currently delinquent on mortgage payments or is at risk of becoming delinquent in the immediate future; and 3) the borrower’s debt-to-income ratios. While the first two factors seem relatively straightforward, understanding your debt-to-income ratios is oftentimes confusing and may seem complex.

What is a debt-to-income ratio?

Simply put, a “debt-to-income ratio” (DTI) is the percentage of a homeowner’s gross monthly income that goes toward paying the homeowner’s debts. In the context of a home loan modification, two DTI ratios are considered: a “front-end” DTI ratio and a “back-end” DTI ratio.

Why are Your Debt-to-Income Ratios Important?

Because lenders want to avoid as much risk as possible, they will pay special attention to your DTI ratios. In essence, lenders use your DTI ratios as indicators of your ability to repay your debts. Therefore, if your DTI ratios are low, lenders may be more inclined to assist you because they believe that you have a higher probability of repaying your debts. On the other hand, if your DTI ratios are high, lenders may be less likely to assist you because they believe you have a lower probability of repaying your debts (and, therefore, you are a greater risk).

Because your DTI ratios play such a significant role in the home loan modification process, it is a good idea for you to do a rough calculation of your own front-end and back-end DTI ratios before seeking a loan modification. By doing your own calculation, you can estimate whether a lender is more likely or less likely to grant you a loan modification.

How Do You Calculate Your Front-end DTI Ratio?

To calculate your front-end DTI ratio, you divide your total “monthly house payment” by your gross monthly household income:

           Monthly House Payment ÷ Gross Monthly Household Income= Front-end DTI Ratio

Your “monthly house payment” is often referred to as “PITIA.” “PITIA” is defined as principal, interest, taxes, insurance (including homeowners insurance and hazard and flood insurance) and homeowners association fees (if applicable). Note that if you pay property taxes, insurance, and/or homeowners association fees separately from you mortgage principal and interest, these expenses need to be added to your total “monthly house payment.”

Examples

1)    Mr. Smith’s monthly house payment is $1,100. Mr. Smith is a carpenter and his gross monthly household income is $2,700. To figure out his front-end DTI ratio, Mr. Smith takes the amount of his monthly house payment ($1,300) and divides it by the amount of his gross monthly household income ($2,700). Mr. Smith’s front-end DTI ratio is 40.7%, because $1,300 ÷ $2,700= 40.7%.

2)    Mr. and Mrs. Baker’s monthly house payment is $1,900. Mr. Baker is an electrician and his gross monthly income is $2,800. Mrs. Baker is a seamstress and her gross monthly income is $1,200. Combined, Mr. and Mrs. Baker’s gross monthly household income is $4,000. To figure out their front-end DTI ratio, the Bakers take the amount of their monthly house payment ($1,900) and divide it by the amount of their gross monthly household income ($4,000). The Bakers’ front-end DTI ratio is 47.5%, because $1,900 ÷ $4,000= 47.5%.

How Do You Calculate Your Back-end DTI Ratio?

To calculate your back-end DTI ratio, you add up all of your monthly debt payments (do not include any expenses that are not listed on your credit report), which may include:

·      Your “house payment” or PITIA (this was used in calculating your front-end DTI)

·      Credit card payments

·      Automobile loan or lease payments

·      Alimony/child support

·      Educational/student loan payments

·      Any personal loans

·      Any other accounts reported in your credit reports

After adding all of these monthly debts up, you then take the total and divide it by your total gross monthly household income:

Monthly Debt Payments ÷ Gross Monthly Household Income= Back-end DTI Ratio

Examples

1)    Mr. Smith’s monthly debt payments come out to $1,700 ($1,100 for his monthly house payment, $300 for his car loan, and $300 for alimony). Mr. Smith is a carpenter and his gross monthly household income is $2,700. To figure out his back-end DTI ratio, Mr. Smith takes the amount of his monthly debt payments ($1,700) and divides it by the amount of his gross monthly household income ($2,700). Mr. Smith’s back-end DTI ratio is 62.9%, because $1,700 ÷ $2,700= 62.9%.

2)    Mr. and Mrs. Baker’s monthly debt payments come out to $2,300 ($1,900 for their monthly house payment, $200 for their car lease, and $200 in credit card payments). Mr. Baker is an electrician and his gross monthly income is $2,800. Mrs. Baker is a seamstress and her gross monthly income is $1,200. Combined, Mr. and Mrs. Baker’s gross monthly household income is $4,000. To figure out their back-end DTI ratio, the Bakers take the amount of their monthly debt payments ($2,300) and divide it by the amount of their gross monthly household income ($4,000). The Bakers’ back-end DTI ratio is 57.5%, because $2,300 ÷ $4,000= 57.5%.

3)    Ms. Garcia’s monthly debt payments come out to $1,600. Ms. Garcia is a civil engineer and her gross monthly income is $5,000. To figure out her back-end DTI ratio, Ms. Garcia takes the amount of her monthly debt payments ($1,600) and divides it by the amount of her gross monthly household income ($5,000). Ms. Garcia’s back-end DTI ratio is 32%, because $1,600 ÷ $5,000= 32%.

Why Do Your DTI Ratios Matter and What Should You Do?

Today, lenders have specific target ranges and limitations on allowable DTI ratios for loan modifications. Although your lender may have slightly differing DTI ratio targets and limitations, most lenders are willing to grant loan modification to homeowner’s whose DTI ratios are below 50%. Remember, lenders want to avoid risk and only want to extend loan modifications to homeowners who have a high probability of repaying their debts.

Therefore, it is a good idea for you to do your own initial front-end and back-end DTI calculations so that you can get a general sense of whether a lender is more likely or less likely to grant you a loan modification. When doing these calculations keep in mind that DTI ratios well below 50% are ideal. Doing these calculations can save you time in determining whether a loan modification is right for you or whether another option might be more advantageous to you in protecting your house.

As always, remember that the earlier you look into the requirements of loan modifications and begin the process, the better. Start by doing your own front-end and back-end DTI calculations and go from there. If you have questions, do not hesitate to ask for help. Also, remember that a qualified attorney who has experience in working with loan modifications can be extremely beneficial to you and can assist you in working directly with your lender and in protecting your interests.

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The first thing you should do is record your judgment at the County Auditor’s office.   By recording your judgment, it becomes a lien on all real property owned by the debtor in that county. 

You have several options for collecting on your judgment, so take the time to investigate the most efficient way to do so.    Judgments in Washington State are good for ten (10) years.  If you have not collected on your judgment at the end of the ten year period, you can renew your judgment for another ten (10) years as long as you do so within 90 days of its expiration.

One method of collection is to garnish the debtor’s wages or bank account.  You must know where the debtor works or banks and there must be enough funds or income available that are not exempt from garnishment.

A second method of collection is to execute on the debtor’s personal property.  This involves taking non-exempt property from the debtor’s residence or business and selling it at auction.  You must have sufficient funds upfront, including the Sheriff’s fees, mover’s fees, storage fees, and auction fees.

A third method of collection is to execute on the debtor’s real property.   This also involves taking the debtor’s property and selling it at a public sale.  Again, the debtor will be permitted a certain amount in equity that is exempt from execution.   You must also demonstrate that the debtor did not have sufficient personal property to execute on first.

Finally, you may be able to sell or assign your judgment to a third party such as a collection agency.  These companies will either buy your judgment at a reduced amount or will attempt to collect the debt on your behalf, charging a percentage of the judgment or a fee.

In order to find out exactly where the debtor banks and works and to find out the assets available for execution, including how much equity there is, you can have the debtor ordered to go into court and testify under oath in supplemental proceedings.   In addition, you may require the debtor to bring documents with him such as his tax return or pay stub. 

It is important to remember that even with the availability of these collection tools, you may not be able to collect on your judgment.  Some debtors are known as “judgment proof.”  This typically means that the debtor does not have enough income or assets to satisfy your judgment or that you simply cannot locate the debtor to determine whether or not there are.   Of course, twenty years is a long time and people’s circumstances can change so even if you cannot collect on your judgment right away, it may be worth your while to periodically check the debtor’s status.  

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