Mortgage trouble? Walk away.

Good morning. I'm splitting the Jim Cramer post in two, because the trashing of the Inland Empire (he says it's such a housing disaster it needs to be plowed over) is overshadowing his advice to upside-down homeowners: just walk away from the house and the mortgage.

Cramer on walking away: "When your house drops 20% in value, then it doesn't matter whether you're prime or subprime. It's better to walk away, even if you're wealthy. Because you don't want to lose your credit card, and you don't want to lose your car. Your house is the one thing that's fungible. It's smart to walk away... It's actually a good thing. I know that sounds a little counter intuitive. But if your home declines 20% in value, it's really important to sell it, or walk away from it."

Strong stuff considering this guy is probably the most prominent investment advisor on television today.

Your thoughts? Comments? Play investment advisor for a second: what do you advise someone who paid $500,000 for a house, still owes all the principal, and the house is now worth $400,000?

Comments

[gerald]

considering it may go down another 100K, it may not be such a bad idea

[Inland Empire]

Besides the possible negative tax consequences discussed elsewhere on this board, can anyone verify the claim that once you have a foreclosure it never goes off your credit history? This was told to me by someone who went thru the process awhile back but I am wondering if things have changed.

[don Hosek]

It astonishes me how many financial advisors don't know diddly-squat about the tax consequences of their suggestions. In the scenario that you come up with, if the former owners have zero other income, they will owe taxes somewhere between $17,848 (married filing jointly) and $22,600 (married filed separately) just in Federal taxes. It'll be another $5-6,000, again assuming no other income. A more likely scenario (where they are employed) can put their tax burden as high as $44,000. All this assuming that the $400,000 number is the net revenue from the sale (after all costs of the transaction are paid).

If they can afford the payments, then they really don't want to do a short sale or foreclosure. If they can't afford the payments, they don't really have a choice, but going into a short sale/foreclosure voluntarily seems like it would be a bad choice for most people.

[AZ]

I have to assume he's only offering this advice to people who are nearing foreclosure

[Cal]

I have zero idea about this from a tax liability POV, but if it is a PURCHASE MONEY loan (very important distinction, as opposed to a REFI ) then in California they can either go after you for the shortfall OR take the house, not both. I wouldnt think you'd have a tax liability then and could walk away with dinged credit.

I would love to hear a CPA take on the difference between purchase money foreclosure and a non-purchase money foreclosure as far as tax liability.

When I read what these people are doing to save underwater houses, taking 3 jobs, draining retirement accounts, etc. It is purely insane, a short sale or walking is a serious option if staying isnt economically feasible.

[Michael Vititoe]

I purchased a house here in CA for 430K two years ago and the value is now approximately 400K. It was a 80/20 loan (2) package. I can't refinance or renegotiate due to being behind in my current mortgage payments. If I let them foreclose and walk away am I liable legally? Are there tax consequences? How long wil my credit be impacted?

[Cal]

Mike, IMHO the 2 people I would talk to are 1) Your loan servicer to see if there is any loan modifications they will do (UNDERSTAND anything they send you to sign before signing) 2) a CPA to find out your exact liability if you choose to walk.

[appraiser1]

Quote from Cal: "I have zero idea about this from a tax liability POV, but if it is a PURCHASE MONEY loan (very important distinction, as opposed to a REFI ) then in California they can either go after you for the shortfall OR take the house, not both. "

Cal is right, there is a difference between a purchase money loan and a re-fi in California...with a refi the lender can pursue judicial foreclosure (and nab you for their losses upon reselling the property) but with a purchase money loan, they cannot; they just eat it (subject to some limits, as I recall...check with your attorney.) Another reason lenders encouraged everyone to refi!

My understanding of the income tax situation is that it is the same in either case: you have been given a "gift" of the difference between the loan remainder and what they sell it for eventually. Free money that you never see, essentially.

[Cal]

I was confusing state vs federal, the Feds dont care what state the foreclosure happened in. This was a good summary of the liability incurred by debt forgiveness in a foreclosure:

http://www.themortgagereports.com/2007/05/how_the_irs_get.html

[AnnS]

"I purchased a house here in CA for 430K two years ago and the value is now approximately 400K. It was a 80/20 loan (2) package. I can't refinance or renegotiate due to being behind in my current mortgage payments. If I let them foreclose and walk away am I liable legally? Are there tax consequences? How long wil my credit be impacted?

Posted by: Michael Vititoe "

Michael, you are in a not good position.

Here are the options:

(1) Try to sell the property for enough to clear the mortgage. If that can''t be done, then

(2) ask you lender if they will let you sell it for what you can get and forgive the difference between the selling price and what would still be owed on your mortgage. That difference between the selling price (lower) and what you owe (higher) will be considered income to you. You will have to pay income tax on it and how much depends upon your tax bracket with that amount added to your other income. This proceedure is called a 'short sale' and will show up on your credit report as a NEGATIVE thing that will hurt your credit. The lender writes of the difference that they 'forgave' as a bad debt. All the 'forgiveness' means is they won't sue you for it.

(3) If it goes to foreclosure, the lender (creditor) will arrange for a foreclosure auction to be held. The property will sell to the highest bidder. Typically, if the price isn't getting to a point equal to or greater than the amount of the mortgage and all the fees, then the lender will bid on the property for an amount equall to what they are owed (and they will try to sell it through a relator later.) Since the lender bid and 'paid' the purchase price in amount that is equal to what the lender is owed, you walk away owing nothing. There is no income to you as the bid paid the amount due, and thus, no tax consequences.

It would be highly unusual for the lender to let it be sold for less than they are owed. If they did let it go for less than they are owed, then you are still liable for the difference and the lender can sue you for it.

Unless the lender gives you a written document releasing you for any amount still owed after the foreclosure sale, you are on the hook for the difference for somewhere between 10-20 years at least depending upon the laws of the state. The odds of the lender releasing their claim agianst you for the balance are somewhere between Slim and None and Slim just rode out of town.

If there is still an amount owed after the foreclosure sale and you do not pay it, it will go on your credit record as a bad debt,

If the house goes to foreclosure, you are basically seriously screwed on your credit record. You will usually pay a lot higher rates for car insurance, individually purchased health insurance, and credit cards and anything else like that.

You can expect to have a hard time renting a place - landlords do credit checks and a foreclosure is a huge black mark.

You can expect to have a hard time getting a job - employers do credit checks and agian it is a huge black mark that will take your credit score into the sub-basement. (A 'short sale' ahs pretty much the same effect unless you personally pay the lender the difference between what is owed and what the house brings.)

You can expect to have financial problems because of your credit score and the foreclosure/short sale being on it for at least 10 years. The credit reporting agencies only go back and cover 10 years last time I checked.

I'm a retired lawyer.

[Cal]

"I'm a retired lawyer."

I can see why you are retired, the difference between a recourse and non-recourse loan is significant. And he clearly stated it was a purchase money loan (therefore, non-recourse).

This is simply untrue:
"you are on the hook for the difference for somewhere between 10-20 years at least depending upon the laws of the state. The odds of the lender releasing their claim agianst you for the balance are somewhere between Slim and None and Slim just rode out of town. "

I think Mike would be best served by talking to a CPA to figure out just where he would stand if he let the house go back to the bank. I think there are offsetting factors (possible losses to offset the forgivent debt that the lender will 1099, saving 3 months rent by letting the house go into foreclosure and not paying, etc) and the whole picture should be gained from a competent professional so he can make an informed decision.

I dont think either the IRS taxation or the credit report hit are insurmountable, lenders are still making loans to people who have had foreclosures 12 and 24 months ago. I think if Mike lived within his means and worked on his credit, in 2 years he'd be in a pretty good place as far as getting another home.

[Alvin]

AnnS,

Thanks for the informative post. However, don't some states, including California, designate the original mortgage used to purchase a home as non-recourse debt? or does the use of 80/20 100% financing make it recourse?

[www.BetterVillage.com, XYZ, PDq.]

Are you guys talking about a deficiency judgement?? I haven't heard the term non-recourse used in conjunction with residential loans; plenty in the commercial world where entities are involved, and recourse versus non-recourse is often negotiated and establishes whether the individuals behind the entities will be on the hook or not.

[RJB]

I think California has Deficiency Judgment statute. see C.C.P. 580d (California)

[mbagrad]

I have a cousin in this position in Riverside. He's trying to hold on but it already cost him a raise because he couldn't sell to take advantage of a job offer in El Centro...

personally it seems if all these people can just hold on for the next 10 years until the next boom they'll be alright.

On the other hand, I think people really can't hold on that long because most of the loans made in the last 2 years were not sustainable for that long.

Another foreclosure just went down a couple of blocks from me - that makes four within a 10-block square in Atwater Village. So it's not just IE, despite what we Angelenos might hope. I'm just glad I didn't buy last year!

[Brian G.]

Cramer is an idiot, he will say absolutely anything to get ratings. I can't believe that he is actually saying this on TV. Look at his track record. He is just as likely to be wrong as he is to be right. Flip a coin and you will be just as well off. So two years of home sales and everybody has a subprime mortgage. I don't think so. I bought just last year and my house is down maybe 10% and the thought of selling has never entered my head. What does Jim Cramer know about Los Angeles anyway?

[Brian G.]

What is the alternative? Move out of your HOME and rent an APARTMENT? This is more lunacy from Jim Cramer. Most of the homes being forclosed on are not very desirable and causing the market to go down, thanks to the speculators in real estate. Subprime is way overblown and is a tiny fraction of the housing market as a whole. If you thought you could afford your house and it suited you when you bought it, what has changed? I think it is dangerous to try to time a market and I would not give my house unless I had no other option.

[Pat]

If you thought you could afford your house and it suited you when you bought it, what has changed? I think it is dangerous to try to time a market and I would not give my house unless I had no other option.

Posted by: Brian G. | August 01, 2007 at 03:36 PM

For some, what changed was the sad realization that in fact, they could not afford their house.

[RJB]

The deficiency judgment thing has been bugging me, so (as a law student) I did some research. Basically, if the mortgage is “purchase money” (meaning what you used to buy the house) then no deficiency judgment is allowed. This rule would apply even if you did 80/20 as long as both loans were purchase money. See California Code Civ. Proc., §§ 580 (b).

However, a debtor could be subject to a deficiency judgment on a second mortgage obtained after purchase if the first forecloses and the second is not paid. This rule comes from case law and the interpretation of Code Civ. Proc., §§ 580 (d). 580 (d) would also bar a deficiency judgment on a refinanced mortgage, but again would not necessarily bar a second from getting a deficiency judgment.

If you are in this situation you should seek professional help because there will be tax consequences. see http://caselaw.findlaw.com/data2/californiastatecases/b119099.doc
for a good discussion about the law in this area.

[Teresa Rothaar]

Erm, does Mr. Cramer have any idea what kind of FICO score is needed to rent an apartment? It is far, FAR more difficult to qualify for a lease than to qualify for a mortgage. The only landlords who will rent to people with subprime FICO's--and especially people with FORECLOSURES on their credit reports--are outright slumlords. Heck, a lot of landlords won't even rent to people if they have no black marks, but the LL thinks they have "too much" credit card debt. Self-employed people also have a difficult time, as do people who haven't been at one job for several years.

Where, exactly, are you supposed to go live after walking away from your house? In a shanty, complete with vermin, collapsing ceilings, faulty plumbing and electrical, and mold? Because that IS where you will end up living. Those are the only LL's who will rent to you. And then you'll, what, report the LL? That's great. Then the state will condemn the place and you'll be back looking for another place to live.

It's better to hold onto the house by any means necessary. Get a second job if you have to. But don't just "walk away" from your house; you will step into a nightmare that dwarfs what you are experiencing now.

[Romepower]

I bought a home in AZ for 222K...I had a loan for 178K and one for 44K. I refiid the 44K and got 32K in cash to pay credit cards and bought 20K in Land. Now I owe 256K and the home is worth 170K. I'm having a hard time to keep paying 1500 a month interest only loan and I'm thinking of walking away. Other than the Foreclosure in credit and destroying my credit for some years..can the bank go after me for the difference of the current 256K loan and what is sells for? I heard AZ don't have Deficiency Judgments for properties less than 2.5 acres and used for single family primary residence. Please let me know what will be the consequences if I walk away.. I can't continue to pay for it...

[Brian Holden]

Romepower - and for anyone else in the same situation. Anyone facing foreclosure should be aware that there is one very important alternative to avoid the foreclosure and that is the Short Sale. A Short Sale is a proven way for a homeowner who owes more than the house is worth to avoid a foreclosure and the subsequent credit hit.
I would advise anyone facing foreclosure to discuss their situation with an experienced Realtor. Short Sales are not a part of real estate basic training but there are a number of educational seminars a Realtor can take to get up to speed. Lenders will pay a reasonable selling commission so Realtors have an incentive to get involved in Short Sale situations.
The basic requirements for a Short Sale are a Listing Agreement with a Realtor and a Sales Contract from a Buyer which are submitted to the Lender along with a Hardship Letter from the Seller explaining why they cannot continue to pay the mortgage and supporting documents such as tax returns, bank statements, information and photos of the home and the Comps, or comparative home prices supporting the offer. The way mortgages are sold, the lender can be anywhere in the country and certainly not aware of local real estate conditions.
If the package is complete, the Lender will order a BPO, or Broker's Price Opinion, from an independent Realtor. Ths BPO is the key to the whole process. If it is too high, the Lender will not accept a low offer. Your Realtor can meet with the Agent doing the BPO and offer information supporting the offer, such as the average time on market of comparable homes, recent selling prices and point out any defects in the home. Most Lenders will accept an offer lower than the BPO, but usually not much more than 10% lower, though that will vary depending on the company.
The sales contract should specifically state that the offer is contingent on the Lender accepting the purchase price in full and forgiving the Seller the deficiency on the mortgage. Yes, there can be tax consequences. The Seller does receive a 1099 on the forgiven part of the mortgage, but there are provisions in the tax code for the offset of the phantom income due to insolvency. Most Short Sellers will satisfy the insolvency requirements or the Lender would not be allowing the Short Sale in the first place. Be aware too that if the home goes to foreclosure, a 1099 is received for the FULL amount of the mortgage, plus late fees, legal fees etc. Obviously every situation is different so a CPA or tax attorney should be consulted.
The process does all take time and Lenders are swamped, expect at least 2-3 months before a sale can be finalized, even if the Lender accepts the first offer. If they do not, the price can be negotiated.

I am a Realtor, a Broker Associate and I am involved in Short Sales. It is a detailed but fairly straightforward process that can work to benefit Buyer, Seller and even the Lender. The Buyer gets a good price on a home, the Seller gets to avoid the disruption and credit hit of a foreclosure and the Lender avoids the delay and expense of foreclosing on a property they don't want to own and that would negatively impact their ability to make more loans.
All this information is available on the web site
www.free-foreclosure-information.com

[investorguy]

Any lender can try to file a 1099 for the difference, but the IRS is getting its ass kicked trying to collect. Most IRS claims are being thrown out if the bank was able to sell the property and recoup its money. Unless your attorney or agent negotiates it, you will get a 1099 for a short sale -- so make sure they exclude that in your negotiation.

A short sale is NOT always your best option, but make sure you have an agent who has done a dozen or more of them successfully. And remember that to avoid the tax consequences -- or at least the battle -- you have to go BK before the foreclosure.

A foreclosure stays on your report 7-10 years, IIRC, as does a BK. But in some cases, BK is the smarter alternative in CA because you can be back up and running much faster. The CA qualifying level for a family of three is $64K or so. If you own a home with a mortgage that has reset, you'll easily meet that means test and can go Chapter 7.

The new BK law is rigged for the banks and CC companies, not the consumer. The BK court looks at the PAST 6 months income -- they don't give a damn if you just now lost your job. If you made 100K a year before, that;s what they look at. There aren't as many BK attorneys as there used to be under the new law -- there are 50 or so in LA who know what the hell they are talking about.

After BK, you'll get secured credit card offers within a few weeks. And you'll be able to get a mortgage -- at a high interest rate -- within 6 to 12 months. In two years, you'll be business as usual with a BK. The BK will still be on your report, but it wipes the slate clean and lenders know you can't go BK again for 8 years.

Your mileage may vary -- consult an attorney.

Theresa: BS. Most landlords won't check your FICO. They say they will, but they don't. And if you are upfront about what happened, you can work around it.

[Marco Delgado]

Bottom line: What is the best advise for a person facing foreclosure? Letting it go? or Doing a Short sale (with a second loan)? What are the tax liabilities?

[jeff]

i refinanced a home in AZ for 530K...I got an 80/20 loan for 424K and one for 106K. (no cash out-just rate and term). I cannot keep up the payments, and now the home would be lucky to sell for $430k. Can the bank go after me for the difference of the loan and what is sells for? I heard AZ doesn't have Deficiency Judgments for properties less than 2.5 acres and used for single family primary residence. Question: I did not purchase the home; it was a 100% refinance (80/20). Can the bank go after me for a Deficiency Judgment?