Foreclosure - the two-headed dragon

I had a customer who just lost his house to foreclosure. In the end he was resigned to the fact that the house was gone and he was just ready to get it over with. What he doesn’t realize is that it’s not over with, yet. This foreclosure dragon has two heads and the second one is waiting to bite him.

It’s bad enough that he lost the house and ruined his credit for the next 12 years. Later this year or next year, the other head of this dragon will come to bite him, when he gets his tax bill from the IRS.

For some time now, the IRS has been treating the amount that the mortgage company ends up losing on the house, and thus “forgiving” on the mortgage loan, as unearned income and thus taxable. The mortgage companies are required by law to report this “unearned income” to the IRS and they then come after the person who defaulted on the loan for the taxes due on that income.

Here’s an example of how it works. Say the home was mortgaged to the hilt and the mortgage was $300,000. When the home owner defaulted, maybe values had declined, or maybe he had let the home go and it’s market value fell. In either case, say the bank was only able to get $225,000 for it after they foreclosed. The remaining $75,000 they had to write off as “forgiven debt” on the loan and report that to the IRS. The IRS is now going to come after taxes on that amount from the ex-homeowner. If the person who defaulted is in the 24% tax bracket, that could amount to $18,000 that this person would owe. That is the second, and usually unexpected, consequence of the foreclosure.

There's also a chance that the bank will come after the ex-owner with a civil suit for the difference between what they get and the amount owed, but that's another head on an already ugly dragon. So the moral of this story is to try extra hard to avoid foreclosure, because it really is a two headed dragon that will burn you twice.

Call a Realtor if and when you get the first delinquent payment notice from the bank. He/she will likely advise you to try to contact the bank and try to work out some sort of payment plan with them. Banks really don't want to go through the foreclosure process and they really, really don't want or need more foreclosed inventory right now, so most will try to work out something with you to avoid foreclosure.

If circumstances dictate that you need to sell, at least get your Realtor started and involved with the process well before you receive a notice that your home is going to Sheriff's Sale. You can authorize your Realtor to work with the bank to come up with a "short sale" plan to help market the house. Only you can get that permission. The banks won't work with your Realtor unless you've called or written and designated a Realtor as your agent. Call the bank and ask for the manager of the foreclosure department to get that process started. Don't wait for the foreclosure dragon to come breathing down your neck (twice).