A little-publicized aspect of the Fiscal Cliff resolution reached at the beginning of this year was an extension of the Mortgage Debt Relief Act of 2007. Without that extension, it is possible that most short sales would have come to a screeching halt as homeowners would suddenly be facing huge tax liabilities if their mortgage debt was forgiven, which could likely have resulted in many more properties going through the full mortgage foreclosure process. This article will explain how this extension benefits Community Associations, although those benefits may come to an end in 2014.
What is a Short Sale?
A short sale, which is the most popular mortgage foreclosure alternative, involves the homeowner selling their property for an amount less than what they owe on their mortgage and other liens, including perhaps community association liens. In a short sale, the mortgage lender(s) and other lien holders (including possibly Community Associations), agree to accept less than what they are owed in order to allow the sale to go through. The goal of a successful short sale for the owner is to not only be able to sell the home, but also to obtain a cancellation of the remaining debt that was not paid to the bank from the sale of the home.
A critical component of a successful short sale is the forgiveness of the deficiency between the amount that the bank is owed and the amount it ultimately collects. Without the cancellation of that debt, the lender could later come back and sue the homeowner for the deficiency amount.
Benefits of Short Sales to Community Associations:
As a starting point, Community Associations usually benefit from short sales and deeds-in-lieu of foreclosure because any past due assessments owed by the homeowner are often paid in full at the closing. Even where past due assessments are only partially paid in a short sale, a Community Association benefits from having a new owner in place that will timely pay all future assessments.
When a property is foreclosed by the bank, Florida law provides limitations on the foreclosing lender’s liability for past due assessments. At a certain point the bank will not be liable for any additional assessments due on the property no matter how long the foreclosure takes to complete. According to RealtyTrac, the average foreclosure in Florida took 853 days to complete in 2012, but in most cases the bank completing the foreclosure would only be liable for 365 days-worth of assessments… or possibly even less. As a result, Associations can routinely lose out on thousands or even tens of thousands of dollars in past due assessments when a bank takes title to a property after a mortgage foreclosure.
In short, as a general rule, a successful short sale is more financially beneficial to a Community Association than a mortgage foreclosure.
IRS Treatment of Debt Forgiveness:
In general, the IRS treats forgiven or cancelled debt as ordinary income, which must be reported and taxed. Historically, this has meant that any debt cancelled in a successful short sale resulted in additional taxable income for the homeowner, who must then pay taxes on the amount of cancelled debt at the applicable tax rate. For example, if a lender agreed to accept $100,000 from the closing of a short sale as full settlement of a mortgage with a balance of $200,000, then the homeowner would receive a Form 1099-C form from the lender and could be required to pay taxes on the $100,000.00 cancelled debt as if it was income. Under this scenario, the homeowner completing a short sale could be facing a tax bill of $25,000 or more! Obviously, this takes away much of the incentive for completing the short sale.
Mortgage Debt Relief Act of 2007:
Because of the potential massive tax bills for homeowners resulting from a short sale and the brewing housing crisis, Congress enacted the Mortgage Debt Relief Act of 2007, which created an exemption for certain cancelled debt related to the purchase of a principal residence from being considered income. As a result, with some limitations, most homeowners who are able to complete a short sale of their primary residence are not required to treat cancelled debt as ordinary income.
The Mortgage Debt Relief Act, however, was only intended as a temporary measure and was initially scheduled to expire at the end of 2012. Fortunately, the resolution of the Fiscal Cliff enacted earlier this year also included a one-year extension of the Mortgage Debt Relief Act. Without that extension, homeowners completing a short sale of their principal residence would once again be facing potential massive tax bills, and it is likely that short sales would drop significantly.
The logical result of a drop in short sales and corresponding increase in foreclosures would be less revenue for Community Associations. While this issue has been temporarily put on hold, unless there is a further extension of the Mortgage Debt Relief Act, Community Associations may see a drop in revenues in 2014. Hopefully the housing market will be recovered enough to soften any drop, but it could be an issue we face in the not too distant future.
This article is for informational purposes only and not intended as legal or tax advice. It is important to note that there are other exemptions that may apply to prevent a homeowner from
owing taxes on their cancelled debt. If you are contemplating a short sale or deed-in-lieu you should consult a tax professional.