Foreclosures, Short Sales and Deeds in Lieu

Courtesy of Old Republic Exchange Company:

While most people understand that foreclosures, short sales and deeds in lieu of foreclosure have significant economic consequences (loss of property; loss of equity; and loss of credit rating), what is not apparent to most people is that there are significant taxable consequences even if the owner walks away with no cash. While an IRC §1031 tax deferred exchange can, in theory, be utilized under these circumstances to defer the capital gain tax consequences, certain practical and technical challenges may make a tax deferred exchange problematic for many taxpayers.
Foreclosures, Short Sales and Deeds in Lieu, are defined, as follows:
Foreclosure: Foreclosure is an involuntary process whereby a lender repossesses property that was pledged as collateral for mortgage debt. Foreclosure can occur judicially (i.e. through a court action) or non-judicially, where a third party, such as a trustee, has the power to conduct a sale of the property after the lender has declared a default of the loan.
Short Sale: A short sale occurs when an owner sells property for less than the debt owed on the property. The lender must consent to the sale, agree to accept less than the full loan amount, and agree to release the property from the mortgage lien.
Deed in Lieu of Foreclosure: A deed in lieu of foreclosure occurs when an owner conveys property to the existing lender in exchange for cancellation of the mortgage debt—i.e. “in lieu” of a foreclosure by the lender.
Taxable Consequences of Foreclosures, Short Sales and Deeds in Lieu:
Each of the above circumstances results in two potential taxable consequences to the owner; (1) tax on gain; and/or (2) tax on cancelled or forgiven debt. Whether the debt is recourse or non recourse dictates whether there is one or both of these tax consequences.
Non-Recourse Debt: (borrower not personally liable)
There is one tax consequence. Capital gain is taxed at the applicable capital gains rate—either 5% (for those in the 10% and 15% income tax brackets) or 15% (for those in the 25% or higher income tax brackets). The amount taxed is the difference between the debt and the adjusted basis. There is no tax on cancellation or forgiveness of debt.
Recourse Debt: (personal liability to borrower)
There are two tax consequences:
(1) Cancellation or forgiveness of debt is taxed as ordinary income. The amount taxed is the difference between the debt and the fair market value (“FMV”); and
(2) Capital gain is taxed at the applicable capital gains rate—either 5% (for those in the 10% and 15% income tax brackets) or 15% (for those in the 25% or higher income tax brackets). The amount taxed is the difference between the adjusted basis and the FMV.
Given the foregoing, there is always the possibility that there is a taxable gain even when the owner receives no cash.
For example: Smith buys an apartment building in 1978 for $400,000 cash. The property appreciates in value, and in 1992, he obtains a loan of $350,000. The property continues to appreciate and—by 2004—the building’s FMV is $2 million. Smith obtains a second loan of $850,000. However, in 2010, the property diminishes in value to $1 million, but his outstanding loans total $1.2 million and he is struggling to make the payments. Smith considers a short sale for the FMV of $1 million. Since Smith has owned the building for over 33 years, he has fully depreciated it and the adjusted basis is $0.
Tax consequences if debt is non-recourse:
If the debt which is the subject of the foreclosure, short sale or deed in lieu of foreclosure, is non-recourse, capital gain must be recognized to the extent the debt exceeds the owner’s adjusted basis.
In the example above, Smith’s debt is $1.2 million and his adjusted basis is $0. Hence, he must pay federal capital gains tax (either 5% or 15%, depending on his income tax bracket) on $1,200,000 (5% would be $60,000—15% would be $180,000). Additionally, unless he lives in a state with no income tax, he will pay state income tax on his capital gain.
Tax consequences if debt is recourse:
If the debt which is the subject of the foreclosure, short sale or deed in lieu of foreclosure, is recourse,capital gain must be recognized to the extent of the difference between the FMV of the property (here, $1 million) and the adjusted basis (here, $0). Hence, Mr. Smith must pay capital gains tax (either 5% or 15%) on $1 million.
In addition, there is a second tax consequence—i.e. cancellation of debt income. Mr. Smith must pay ordinary income tax (anywhere between 10% and 35%, depending on his income) on the difference between the FMV ($1 million) and the existing debt ($1.2 million). Thus, he must pay income tax on $200,000.
In sum, if the debt is non-recourse, Mr. Smith pays capital gains tax on $1.2 million. Alternatively, if Mr. Smith’s debt is recourse, he will pay capital gains tax on $1 million and he will pay ordinary income tax on $200,000.
Can the tax consequences of a foreclosure, short sale or deed in lieu be ameliorated by a §1031 exchange?
In theory, although structuring a foreclosure, short sale or deed in lieu in the context of an exchange may ameliorate the capital gain tax consequences, these transactions present practical and technical difficulties—if not, complete obstacles – to including them as part of a tax deferred exchange, such as:
• No cash is available to complete acquisition of replacement property;
• Credit is adversely impacted and thus financing to purchase replacement
• property is unlikely;
• In a foreclosure there is no contract of sale for the taxpayer to assign to the Qualified
• Intermediary (required by the Treasury Regulations for an exchange);
• A short sale or deed in lieu may have a written agreement to assign to the Qualified
• Intermediary, but it is questionable as to whether the IRS would accept such an
• assignment.
In sum, owners should recognize that even though their property is under water and they will receive no cash from its disposition, the tax consequences remain significant. Owners facing foreclosure, short sale or a deed in lieu should plan as far in advance as possible for the taxable consequence resulting from the transaction.
For further information regarding the above, you may wish to visit the following link located on the IRS website: http://www.irs.gov/newsroom/article/0,,id=174034,00.html

Double Dip? Don't Think So

After a promising start to the year, the market (as measured by the S&P 500 Index) suffered its worst two-month return ending June 2010 since the two-month period ending February 2009, which was during the depths of the financial market meltdown. The market had much to worry about as concerns over the fiscal issues in Southern Europe, the compounding problem of the Gulf Coast oil spill, an impending contentious mid-term election cycle, and the unknown consequences of Congress’ financial regulation reform kept investors’ fears on the rise and market returns on the decline.

Despite the many external factors weighing on the market, it was perhaps the uneven and somewhat deteriorating economic data, especially in the labor and housing arenas, which turned the stock market recovery into a significant market pullback. The primary question that investors sought an answer to was whether the market was beginning to show signs of a developing “double dip” back into recession or whether the last few months are simply a “soft spot” in an otherwise robust economic recovery and expansion?

The question highlights the longstanding market dilemma of trying to figure out the difference between an economy’s changes in direction versus changes in speed. Like a car, the economy can be either in forward (expansion) or reverse (recession). But it can also be increasing its speed (accelerating or improving economic conditions) or reducing speed (decelerating or worsening economic conditions). During the last few months, economic data has indeed seen softness, which begs the question: are we on the verge of reversing (double dip) or just slowing down (soft spot)?

As far as double dip scenarios, the market has limited history to examine. Only during the Great Depression and the severe recessions of the early 1980s were there ever double dip recessionary episodes. Could now be the next? The likelihood is strongly against it. In order for an economic recovery to turn back into a recession, significant negative catalysts are needed to derail economic growth.

While not downplaying the negative effect of the problems in Greece or the Gulf Coast oil spill on global growth, these events are just not big enough to shift the economic gears from forward to reverse—meaning from expansion to recession. During the Great Depression, it took a significant monetary policy mistake—increasing interest rates which slowed down a very fragile economy—to prompt the double dip. During the 1980s, the Federal Reserve again shifted gears early to slow down economic growth, but this time to fend off soaring inflation, as exhibited by 16% mortgage rates and 14% interest rates. The strategy worked, maybe a bit too well, as the deliberate economic slowdown turned into a double dip recession.

But right now, the economic backdrop is far different. Albeit slower than we would all want, the employment picture is improving, consumers are spending, and businesses are once again changing their focus from cutting costs to investing for the future. But more importantly, the Federal Reserve remains firmly committed to maintaining accommodative monetary policies through ultra-low interest rates in order to continue providing this economy with much needed stimulus. As a result, mortgage rates are at all time lows and loans to fuel business growth are under very favorable terms. All in all, the economic canvas on which this market will paint future returns is supportive of sustainable growth and higher asset prices.

With the threat of a double dip virtually off the table, the most likely explanation for the sluggish economy and resulting market pullback is what is commonly referred to as a soft spot or simply put, a reduction in the speed of the recovery. Soft spots occur in every recovery, usually between 6 and 12 months after the end of a recession. At 11 months after the assumed end of the 2007-09 recession, this soft spot is right on cue. Soft spots are triggered not by any threat of a change in direction (i.e. double dip), but rather at the inflection point when the economic recovery shifts from the robust growth immediately following the recession to the modest, sustainable growth that fuels longer term economic expansions. Back to the car analogy, soft spots occur when the rapid acceleration on a highway onramp shifts to the sustainable speeds of highway driving.

While the global economy continues to face many obstacles, all of which bring down the speed of this economic recovery, I remain convinced that this economy is facing an economic soft spot and not any threat of a recessionary double dip. The market is always concerned when economic growth speed slows, which makes complete sense. But the recent equity market sell-off has priced in a greater likelihood of a severe change in direction (double dip) rather than the more moderate impacts of a soft spot. As a result, I believe that once the economy emerges from its current transition to slower, but still advancing speeds, asset values will be poised to benefit and investment opportunities taken advantage of at these attractive market levels will likely be rewarded. As always, please contact me with any questions.

California Median House Price Rises 23% on Use of Tax Credits

California house prices rose 23 percent in May from a year earlier as homebuyers took advantage of government tax credits, the state’s Realtors group said.

The median price of an existing single-family home was $324,430, the California Association of Realtors said today in a statement. It was the fifth straight monthly increase of at least 10 percent, the Los Angeles-based group said. Prices rose 5.9 percent from April.

California home prices were helped by homebuyer tax credits, the association said. To qualify for a federal credit, buyers were required to sign a contract by April 30 and complete the purchase by July 1. A state credit of as much as $10,000 began May 1.

http://www.bloomberg.com/news/2010-06-22/california-median-house-price-rises-23-on-use-of-tax-credits.html

99.5% Financing and Qualifying with Low Credit

Have you ever worried about your credit rating while considering buying a home? Well, worry no more! With the help of the loan programs available through our affiliates, you can get qualified for a 99.5% financing program and get qualified for a loan with a credit score as low as 530! Here's some more information:

99.5% Percent Financing Program Highlights:

Our program works in conjunction with FHA loans that now will only lend up to 96.5%. Our program gives you the additional 3% needed for in order to secure an FHA loan for a total of 99.5% financing. The other .5% needs to come from you or can be a gift from a family member.

If you are currently employed and have paid your bills on time for the last year, there is a good chance you will qualify for our program.

How Do I qualify:

Must be gainfully employed at least 2 years in same job or profession.

We will need you to provide us with pay stubs and tax returns documenting your income.

Must be current on all bills with no negative reporting in the last 12 months.

Bankruptcy is ok if it is 2 years or older.

Foreclosure/Shortsale is ok if it is 3 years or older.

Collections are ok if not too many active and if none in the last 12 months.

You will need 3 credit references to report positive payments for last 12 months. If you do not have active tradelines reporting on your credit report, we can accept nontraditional forms of credit such as utilities bill or rent payments (For more information on nontraditional forms of credit ask one of our loan officers to send you the nontraditional document).

For Borrowers w/ No Fico Score or Limited Credit:

Provide at least three (3) credit references rated at least 12 months. At least 1
reference must be from Group 1 (Group 1 references should be exhausted before using
Group 2 as Group 1 is more indicative of a borrower’s future housing payment
performance.)

Borrower’s with NO Group 1 references will not have sufficient credit.

Group 1: Rental Housing Payment or Utilities (Gas, Electric, Water, Home Phone, cable
TV). If renting from a family member, provide cancelled checks for documentation.

Group 2: Insurance coverage(Auto, medical, life, renters), Cell Phone, Internet Services, Child Care payments, School Tuition, Retail Stores(Department, Furniture, Appliances, Speciality Stores, Rent-to-Own) 12 month savings by regular deposits with NO Non Sufficient Funds (NSF’s), Auto Leases, Personal loan, Storage Units, etc..

In order to use these other forms of credit you will need to provide us with 12 -24
months of cancelled checks or bank statements showing they are paid with bill pay.
You will also need to contact the providers of these services and ask them to issue you a credit letter on their letter head with their information stating your account history for the last 12 -24 months.


For more information, please visit us at: http://www.appliedproperties.com

1031 Exchanges Come Roaring Back to the Market

For two years 1031s had been few and far between. All of a sudden, a new wave of exchange buyers is looking for product adding to an already excessive buying demand. Read the full article by Robert Knakal, Chairman and Founding Partner of Massey Knakal Realty Services in New York City.

Click here for full article

Selling Your Home for Top Dollar

Thinking of selling your home? Before making such a crucial decision, it is valuable to do as much research as possible. We can help you with our free informative report focusing on the key aspects of selling your home. From buyer psychology to evaluating offers, this report covers the entire home-selling process. Check it out today!

27 Quick & Easy Fix Ups to Sell Your Home Fast and for Top Dollar

Government Agrees to Pay $1500 for Short Sale

The new government-backed short sale program may be just the help you're looking for! For the full scoop, check out:
HAFA – The New Government Backed Short Sale Program