| | Sub-Prime Mortgages and Taxable Income |
| | Published - October 15, 2007 |
| | The news has been dominated the past few months by the topic of Sub-Prime mortgages and the resultant failure of mortgage companies due to defaults in payment. One topic that has floated under the radar is the tax affect on the individual defaulting on the mortgage payment.
Sub-Prime Mortgages and Taxable Income
Mortgage companies have been making loans to individuals who are a poor credit risk, have no down payment, and who take out adjustable interest rate mortgages. As the interest rates have increased, the individual is unable to make the monthly payment on the mortgage. When this is coupled with a decline in the value of the underlying property, the mortgage holder forecloses on the property and takes ownership of the home.
As an example, suppose an individual purchased a home for $300,000 at a 6% interest rate. Typically, the individual had an interest only loan and made a monthly payment of $1,500 ($300,000 x 6% = $18,000 /12 =$1,500 monthly). When the interest rate increased to 8% their monthly payment increased to $2,000 a month. If during this same period the value of the residence decreased to $250,000, the individual simply stopped making payments and waited for the mortgage holder to foreclose on the property.
The prevailing thinking was that as the individual had no investment in the property, they would stop making monthly payments that they could no longer afford, live in the property rent free, just let the mortgage holder foreclose, and wait to be evicted.
The mortgage holder in turn was not interested in being a property owner, and immediately sold the house for whatever they could get. For example, if the house was worth $250,000, the mortgage holder would likely receive $235,000 after paying a real estate commission. In turn, the mortgage holder would then write off the $65,000 in debt as an unrecoverable loss.
However, most mortgage holders are not too happy about absorbing these losses, especially from an individual who is usually gainfully employed, but is likely unable to ever pay off this amount of debt.
What the individual is usually totally unaware of is that a section of the Internal Revenue Code deals with the discharge of indebtedness. When the mortgage holder has written off the debt of $65,000, under the tax law the individual is deemed to have $65,000 of taxable income as the result of the forgiveness of the debt by the mortgage holder.
While the mortgage holder is required to submit a Form 1099 both to the Internal Revenue Service and the individual to report this income, some unscrupulous mortgage holders have been sending the Form 1099 to the Internal Revenue Service, but not too the individual. What happens is that several months after the individual files their US Federal individual income tax return, they receive a notice from the Internal Revenue Service assessing income taxes for the $65,000 shown on the Form 1099, and not reported on the income tax return, and then assessing penalties and interest for failure to report income on the tax return, underpayment of tax and failure to timely pay the tax. So it would not be unusual for the individual to now owe the Internal Revenue Service $30,000 or more in back taxes, penalty and interest.
And unlike the mortgage holder, the Internal Revenue Service will actively pursue this debt by seizing assets and perhaps putting a lien on the person’s salary.
Alternative Planning Ideas
Before a property reached the default point, an individual owner should consider renting the property for more than the current monthly interest payment. During a period when home prices are falling and mortgages are hard to obtain, individuals are more inclined to rent, than buy. The rental income should be set high enough to cover future interest increases and this will also allow the individual time to ride out the temporary decline in the value of the residence.
Principal Residence versus Investment Property
You might wonder as to why the individual did not try to sell the house for the most that they can get, incur a capital loss, and then negotiate the shortfall with the mortgage lender. When a personal residence is sold at a gain, the individual is subject to tax on the gain. However, when a principal residence is sold at a loss, the loss is considered to be a non-deductible loss.
However, if the individual would have turned the house into an investment property by renting it out, and then had to sell, the resulting loss from the sale of the rental property would then be deductible.
The Internal Revenue Service and Debt Collection
The Internal Revenue Service has been under verbal attack by the various Democrat Presidential candidates over the increasing failure by the Internal Revenue Service to collect taxes properly due. And the response f the Internal Revenue Service has been to pursue collection in cases that they would have willingly settled a few years ago.
We were involved in a recent case where a European citizen owed the Internal Revenue Service several hundred thousand dollars. An offer was made to settle the tax due for about 20 cents on the dollar, payable immediately. The Internal Revenue Service rejected the offer, even though they unofficially acknowledged that their chances of collection were about zero. Upon the breakdown of negotiations, the Internal Revenue Service obtained a Federal tax lien against the individual. The result of this lien will be that every time this individual enters the United States in the future, they will be detained at the airport and questioned about their failure to pay the tax lien. We were told that the individual will be allowed to enter the United States, but only after several hours of questioning.
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