Home Security

Dear Julie,
my wife and I bought a home in August 2005 with an option ARM mortgage in hopes of refinancing it in a few years with a fixed-rate loan. We can’t afford our monthly payments and we have been advised to do a “short sale” or just foreclose on our loan. What is the difference and how would this affect our credit history and taxes? —ADRIAN

With Julie Stav

Dear Adrian:
You are not alone. As millions of Americans face the resetting of their mortgage rates as part of their written contracts, they are also watching the values in their homes stagnate, putting them “upside down” on their home loans, meaning they owe more than the value of their property.
Before you consider a “short sale,” which is selling your home for a price lower than your loan balance, call your lender’s loss mitigation department to ask if there could be a modification of the terms of your loan.
A loan modification is similar to a refinance. Your lender may reduce the interest rate, turn your ARM into a fixed-rate mortgage, or even extend the life of the loan to make it easier for you to meet your monthly payments. The effect of a modification on your credit history would depend on how far behind you are on your payments, but it is less damaging than options such as a short sale or foreclosure.
A short sale is an agreement between you and your lender to sell your home right away to pay off part, if not all, of the outstanding debt. In a short sale, you are responsible for making the necessary repairs to the house, paying the real estate commission, taxes and government fees, and giving the lender whatever money is left over. Your credit report will reflect a short sale, which is more damaging to your score than a loan modification.
And that’s not where the bad news ends. In a short sale, your lender has the right to report the difference between the present value of your property and the loan balance to the IRS as income, even if they choose to forgive your responsibility to pay it (called a cancellation of debt). This will result in a tax liability on your personal income tax return.
The reason for this is that when you borrowed the money for your home, you were not required to include the loan proceeds as income because you had an obligation to repay the lender. If that obligation is subsequently forgiven, the amount you received as a loan is really not a loan anymore and is considered reportable as income because you no longer have an obligation to repay the lender.
The same occurs when a home is foreclosed. With a foreclosure, your lender takes possession of your home, evicts you, and puts the property up for sale.
It is estimated that the cost of foreclosure to a lender is approximately $50,000, so it is in the lender’s best interest—and yours—to avoid this solution to the problem. Foreclosures go on your credit report and can remain there for a period of seven years or longer.
On September 17, the Internal Revenue Service unveiled a special new section on their website for people who have lost their homes due to foreclosure. This new section has valuable information, including a worksheet designed to help you determine whether any of the relief provisions apply to you.
If any part of your mortgage obligation is reduced or eliminated, you will receive a year-end-statement—Form 1099-C—from your lender. By law, this form must show the amount of debt forgiven and the fair market value of the property given up through foreclosure. Anyone receiving this form should make sure that the information is correct and must notify the lender promptly in case of any errors or discrepancies.
For more information on possible tax relief due to a cancellation of debt, visit the official IRS site at www.irs.gov/newsroom/article/0,,id=174034,00.html

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