Lifelines for drowning homeowners - By Matthew Finberg

Many homeowners are realizing that their once-sure-thing investment, the American dream of home ownership, has become an anchor around their necks. For reasons ranging from overuse of home equity loans when the sky was the limit for residential real estate appreciation to loss of employment, many are over their heads – or “under water,” as the mortgage professionals call us, when home loan exceeds the value of the property securing its payment.

How did we get here? Aggressive mortgage brokers and unscrupulous appraisers with loose standards certainly made it easy for us to tap paper equity. The government certainly did very little to protect us from ourselves. Playing the blame game may ease your conscience if your home is under water, but genuine options exist to stem your negative cash flow and quite possibly keep that roof over your head.

You are far from alone in this experience: it is estimated that approximately 30 percent of all U.S. homeowners owe more on their mortgages than the value of their homes. With the jobless economic recovery we are experiencing, this figure is bound to increase. Banish the guilt demons which may haunt you and shake yourself out of the paralysis which naturally sets in when faced with what feels like hopelessness. You may feel like you are drowning, but real life lines are available to grab.

I recommend consulting a trusted attorney and real estate broker to help create your personal recovery plan. They can help you evaluate the pros and cons of the following options: (a) negotiating a loan modification which will result in a new payment schedule you can afford; (b) listing the property for sale at a price which may not fully pay off your mortgage debt (“short sale”) but could well end your obligations; (c) requesting that the lender accept a deed of your property in lieu of foreclosure; or (d) letting the property go to foreclosure sale.

Despite your good-faith intention to pay your debts as they come due and to honor the terms of your mortgage, experience indicates that lenders will not even talk to you about your loan unless you are at least three months delinquent on your payments. The lenders’ loss mitigation departments (the folks responsible for working things out with you) are overwhelmed with the volume of nonperforming loans needing their time and attention. Representatives of more than one major lender have told me that you are unlikely to get their attention if your payments are up to date. It may be time to stop throwing good money after bad.

LOAN MODIFICATION. If you are determined to stay in your home, once the lender is paying attention to you and taking your calls, you can explore a loan modification. A number of nonprofit organizations may assist you in this effort, and a good place to start is www.coloradoforeclosurehotline.org. Though worth a try, statistics indicate that few meaningful restructurings are approved, and many that are approved end up in foreclosure notwithstanding the more affordable terms. The reality is that most of the 30 percent of U.S. homeowners who are under water need to move into more affordable accommodations in order to experience real relief.

DEED IN LIEU. In theory, a deed-in-lieu-of foreclosure would free the homeowner from the mortgage debt in exchange for his conveying the property to the lender. The homeowner would write off his equity invested in the property and the lender would acquire the property at the bargain price of the outstanding principal of the debt. The problem with this is that few lenders are interested. By foregoing the foreclosure process, the lender could very well end up with property subject to mechanics’ liens, judgment liens and other title defects which foreclosure could have eliminated. The property is worth less in this condition than after the cleansing of the foreclosure process. The lender would also have yet another real estate asset on its books, which harms its ability to make new loans and otherwise operate profitably. In practice, the deed-in-lieu-of foreclosure action has little appeal to a lender and almost no chance of success.

FORECLOSURE. After a homeowner has skipped three monthly payments, the lender will most likely elect to foreclose on the property in an effort to recover all sums owed. The first step is filing a Notice of Election and Demand with the Public Trustee for the county in which the property is located. State statute imposes substantial obligations on the lender to provide the borrower and other interested parties plenty of notice regarding the proceeding and an opportunity to cure the defaults virtually right up to the day of the auction sale of the property. Compliance with these requirements takes approximately four months after filling the Notice of Election and Demand, so the homeowner can expect to stay on the property for about eight months from the time that monthly payments are suspended before being legally compelled to move. The difference between the bid price at the auction and the amount owed under the mortgage, known as the deficiency, may be pursued in Colorado by suit against the borrower for seven years after the foreclosure sale. The former homeowner has the deficiency hanging over his head as well as the damage to this credit score by the reported foreclosure.

SHORT SALE. A better approach may well be listing the property with a real estate broker and negotiating with the lender to agree to release its lien if a reasonable offer is made, even for less than the amount of the loan. Lenders are interested in short sales as they save them from the marketing and ownership risks of ownership and the balance sheet damage of adding more real estate to its assets (assuming, as is most often the case, that it is the winning bidder at auction), and it may well result in a higher price than a subsequent sale by the lender post foreclosure. The owner with a contract in hand may be in a better position to convince the lender to forgive the deficiency and report the transaction to the credit agencies more favorably than it would a foreclosure, enabling the homeowner to walk away from the closing with a fresh start. The homeowner’s leverage is that most contracts for short sales contain standard language permitting the seller to cancel the contract if he does not like the lender’s terms.

In addition to the credit rating repercussions of any mortgage default, homeowners need to know that a price for debt forgiveness may be taxable income. In general, the amount of the portion of any loan which is forgiven or written off is considered taxable ordinary income. The lender will send such a taxpayer a Form 1099-C reporting the amount of debt cancelled. This is not all bad news. It is official recognition that the lender is not going to pursue a deficiency judgment against the homeowner. Statutory exceptions also exclude the cancelled amount from taxation even though the homeowner must report it in his tax return.

The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt forgiven through mortgage restructuring, foreclosure or short sale qualifies for the relief which is available through calendar year 2012 for up to $2 million of forgiven debt ($1 million if married filing separately). Mortgage debt in excess of the original acquisition debt is not eligible. The forgiven debt may also be excluded if it is discharged in bankruptcy or to the extent that the taxpayer is insolvent immediately prior to the discharge. Insolvency for this purpose is the excess of debt over the fair market value of assets.

If you are one of the 30 percent of all American homeowners who are drowning in their home mortgages, do not despair! Strategies are available which can limit the damage to your credit rating, protect you from a lawsuit for money damages by the lender and exclude the amount of debt cancelled from taxation. Your real estate broker and attorney can work to help you maximize your chances for such success.