How to manage tax liability, avoid big exposure to lender

NORTH BAY – With the rise of foreclosures and short sales, homeowners, commercial property owners and real estate investors should be looking out for some potentially costly pitfalls.

[caption id="attachment_18147" align="alignleft" width="216" caption="Steve Ghirardo, Tom Davenport "][/caption]

Several issues can come up, most notably large unprecedented tax bills, and the possibility of being held liable to the lender if a property is sold for less than the loan value.

Steve Ghirardo, president of Ghirardo Real Estate Group and principal at Ghirardo CPA in Novato, said people call him concerned about cancellation of debt in terms of the tax liability. But he said the taxes are often a minor issue compared with potentially having to pay back lenders on properties whose value has fallen well below what is owed.

With the tax issue, if money is borrowed from a commercial lender and the lender later cancels or forgives the debt, the borrower may have to include the canceled amount as income for tax purposes, depending on the circumstances.

When the obligation is forgiven, the amount received is reportable as income, and the lender is required to report the amount of the canceled debt to the IRS using a 1099.

The Mortgage Forgiveness Debt Relief Act, signed on Dec. 20, 2007, by President Bush, allowed taxpayers to exclude income from the discharge of debt if it was a principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.

This provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion, $1 million if married filing separately. The exclusion does not apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.

So the taxpayer must choose either to exclude the cancellation of debt completely, which results in reducing the benefits of the operating loss, capital loss, credit carryovers and basis, or simply to defer the income for five years and then recognize it.

The situation for every taxpayer is likely to be very different, so looking at the related tax ramifications is key since the election is irrevocable, experts said.

But when it comes to short sales and the liability on the difference of loan to value, “It is the relationship with the lender, that is the issue,” Mr. Ghirardo said.

In California, he said, whether or not the loan is recourse or nonrecourse, once the lender goes through the deed of trust and completes that as a foreclosure sale, the lender cannot go after the borrower for the difference.

That is true no matter what, he said.

However, when a borrower wants to avoid foreclosure and do a short sale, the borrower may be liable to be taxed on the difference. Or there may be a time after the sale closes when the lender comes after the borrower for the difference.

A short sale is a sale by the owner of a property where the amount owed on the property is greater than the amount the seller will get. The lender must sign off on this because the lender is the one that stands to lose on the deal.

Short sales can be desirable for the borrower because they will not have to have a foreclosure on their credit report, and they set the terms.

“Clients come to me concerned about debt forgiveness, but that might not end up being the real problem,” Mr. Ghirardo said.

The real problem, he said, is that lenders are now adding paperwork that the borrower signs that reiterates their liability on the loan. It comes in the form of a letter and gives the lender the right to come after the borrower after the sale is complete for the difference between the loan value and the sale of the property.

So if a borrower took out an initial loan of $500,000 and the home went for $280,000 in the short sale, the lender could potentially come after the borrower for the remaining $220,000.

Tom Davenport of Beyers Costin in Santa Rosa, who focuses on business organization and finance as well as real estate acquisitions, said he has seen these letters.

“And I have advised my clients not to sign them,” he said.

In all cases, he has been successful in negotiating with the lender to change the terms.

“We have been able to get the lender to back off and remove the requirement,” he said.

The statute of limitations for the lender to come after the borrower is four years, the same as any breach of contract.

Timothy Brown, a Realtor with Creative Property Services in Santa Rosa, has focused a lot of attention on short sales.

He has also been successful in negotiating terms with the lender to make sure that the debt is forgiven.

Another issue concerning cancellation-of-indebtedness income is that while the 2009 act allows taxpayers to defer cancellation of debt income for loan modification recognition events occurring in 2009 and 2010, the income is generally deferred for a period of five years (for 2009 modifications) or four years (for 2010 modifications).

Once recognized, the amount is taken into income over a five-year period. So, the big issue to be aware of for this next year is if this is going to be taken advantage of, the loan modification has to happen in 2010, experts said.