Short Sales Would Be Subject to Taxation, Too, If Congress Doesn’t Act
The Federal Housing Finance Agency, overseer of Fannie Mae and Freddie Mac, announced new short sale guidelines that would go into effect November 1. These guidelines are designed to eliminate red tape and encourage short sales as a way for underwater borrowers to get out of their home without going through the foreclosure process. In a short sale, the borrower and lender agree that the borrower can sell their house at a market rate, even if that comes up lower than the outstanding balance on the mortgage. The lender then forgives the remaining mortgage amount.
FHFA offers quite a bit in these new guidelines. Current underwater borrowers will now be able to do a short sale if they have an “eligible hardship.” These include a death of a borrower, divorce, disability, or relocation for a job 50 miles or more away from the home (that includes service members being relocated to a new base). It’s the first time job relocation has been put in the guidelines, and it really relieves some of the conditions that tether borrowers to their homes. Fannie and Freddie will also waive deficiency judgments (i.e. going after the borrower who makes the short sale after the fact, for the balance of the amount owed on the mortgage) if the borrower makes a small contribution to cover the shortfall. And, second lien holders will be offered $6,000 by Fannie and Freddie to expedite a short sale. This isn’t terribly much, but second liens have gotten in the way of the short sale process by seeking a bigger payoff for their loan, so this greases the wheels a bit and codifies the rules with a standard payment offer.
The program isn’t bad, and it should accelerate short sales, which are preferable to foreclosures pretty much all the way around. Short sales are already gaining in frequency, up 25% in the first quarter of 2012, according to RealtyTrac.
FHFA’s announcement got some praise in the financial press, albeit in the midst of protecting them for foregoing principal reductions (Mike Konczal demolishes the argument against principal reductions here). But predictably, everyone is forgetting one thing. In practice, a short sale IS a principal forgiveness. The bank forgives the spread between the final price on the short sale and the balance of the loan. And because short sales operate as a principal forgiveness, then it’s just as vulnerable to the expiration of the Mortgage Forgiveness Debt Relief Act. Homeowners who manage to get a deal with their lender on a short sale after January 1, 2013 would be liable to report the principal forgiveness on the short sale as income for tax purposes, if Congress does nothing. And the FHFA guidelines only kick in on November 1, 60 days prior. It probably takes that long to get anything done on a short sale, find a buyer, and close the deal. So potentially all transactions under the new FHFA guidelines are susceptible to this tax issue.
That means a large tax bill for someone who negotiated a deal with their lender to put their mortgage debt behind them. And while there are potential (but hard to navigate) hardship exemptions to taxation that someone getting a principal reduction can access, the situation for those in a short sale may be very different. That person may have means such that they cannot extinguish the tax debt. It means the government will punish them for having the misfortune of an underwater home.
Where we’re at with the Mortgage Forgiveness Debt Relief Act is that a one-year extension passed as part of a larger tax extenders bill in the Senate Finance Committee. However, that would still have to get to the floor of the Senate, and through the relevant committee and the House, in order to go to the President’s desk. Those are a lot of hurdles to overcome. And despite some promises, I still don’t see much awareness raised on this issue to the level necessary to get it through Congress. Certainly those praising the FHFA’s action on short sales have no awareness whatsoever of the tax implications.