Foreclosure, tax bill a 1-2 punch

Foreclosure, tax bill a 1-2 punch
September 9, 2007

BY SUSAN TOMPOR


The last thing somebody who couldn't pay the mortgage would expect is a tax document in the mail that proclaims they magically got an extra $20,000 in income they never touched.

But that's exactly the tortured tax picture that faces many troubled homeowners in Michigan and elsewhere.

Thousands of families could face an unexpected tax hit if they went through foreclosure, worked out some unusual deals with the bank to refinance or sold homes for less than the outstanding debt.
"This really adds insult to injury where someone is in a situation where they get hit with a tax bill on top of having to lose their house or refinance at a lower value," said U.S. Sen. Debbie Stabenow.

The Michigan Democrat told me during a phone interview that she'd like to see this unfair tax rule change by year-end. On Aug. 31, President George W. Bush gave his support to Stabenow's mortgage relief act as part of his package to assist homeowners.

It's one of those tax rules that not many people know about because home values have typically gone up, not down. Yet, it's a tax issue that now could have great impact on families throughout the country. It would be even more significant in Michigan where consumers are coping with a recession -- on top of a fallout in house prices.

Say a homeowner loses a job in Michigan, needs to move and has to sell the house for $80,000 instead of the $100,000 owed on the mortgage. If the bank forgives $20,000, as is possible in some cases, it's going to generate a 1099 tax form that has to be reported as income.

For many families, an extra $20,000 on that 1099 could mean that they've got to dish out an extra $3,000 or $5,000 or more in federal income taxes.

"The general rule is that cancellation of debt is taxable income," said Bob D. Scharin, RIA senior tax analyst from Thomson Tax & Accounting.

Or take another possibility. The family can no longer make the mortgage payments. So the family negotiates with the bank and attempts to do what's called a short sale -- or sell the property for less than the debt owed on the mortgage. The bank may forgive part of the loan. Again, though, we're looking at another tax hit.

Or how about a homeowner who is able to pay the mortgage at the initial adjustable rate? But then the rate readjusts upward significantly -- and suddenly the mortgage payment is unaffordable.

Say the homeowner would like to refinance.

But there's a snag. Some homes -- especially in some pockets of Michigan -- now are being valued below the original mortgage three, four or five years ago. So the house might be valued at $100,000 instead of $120,000.

And the homeowner might not have enough equity in the house to deal with the difference.

If the bank steps in and refinances the house at say $100,000 instead of $120,000, well, the homeowner still would run up against that tax hit.

"It's typically not a gift. It's considered income -- just like when you win a prize," said Gary Riedlinger, tax research manager for Yeo & Yeo PC in Saginaw.

Except nobody feels like a Lotto winner.

In some cases, consumers are able to avoid the tax hit.

"The one big exception is bankruptcy," said James Jenkins, president of Jenkins & Co., a tax firm in Southfield.

If the debt is discharged in bankruptcy, the tax isn't owed. Another option: Taxpayers could file a complicated tax form, Form 982, to show that they were insolvent -- or had more debts than assets.

"How's the average guy going to possibly know the rules on this?" Jenkins asked, noting that an experienced tax preparer could save some consumers money and avoid much of the tax.

But Jenkins agreed that the rules should be changed to help families during this mortgage mess.

"Sad to say, it's going to be a very common problem," Jenkins said. "You're not ending their misery if they're going to end up with a big, fat tax bill."

Stabenow told me that she's willing to make this a temporary change, possibly for a year or two, in order to get bipartisan support.

She also is willing to limit the tax change to the homeowner's primary residence.

Stabenow noted that many middle-class families have borrowed money to get into a house in a better school district -- and improve their situation.

"They have no control on the broader economy in Michigan," she said.

Stabenow said the banks support this idea because they don't make money foreclosing on homes.

Richard DeKaser, chief economist for National City Corp. in Cleveland, said lenders would have more flexibility in renegotiating terms and avoiding some foreclosures if some proposals went through, including a temporary freeze on the tax burden -- as Bush and Stabenow are proposing.

Changing the tax rules -- even just for a year or two -- won't get rid of the For Sale signs in everyone's neighborhood or cut off the wave of foreclosures. But Stabenow's plan certainly is a sensible, solid step toward fixing an unforeseen problem for many families.