Strategic Defaults and Tax Penalties

In its hay day, the real estate bubble allowed ambitious house-flippers with good enough credit to purchase property with borrowed money. Then came the financial crisis of 2007 when the bubble burst and those not fortunate enough to cash out in time were left with the burden of paying inflated mortgages, or in other words, having an upside down mortgage. What was once a property valued at $1million, lost $400 thousand in value virtually overnight, and yet the monthly mortgage payments remained unaffected. Many Americans were faced with a moral dilemma of sorts - go down with the ship like a good captain should or abandon it and live to see another day 

In order to free up finances for other expenditures, many borrowers are opting for strategic defaults as a means to deal with upside down mortgages. Strategic defaults are an increasingly popular and ultimately inevitable trend in today’s post housing-market crash. At the price of significantly damaging one’s credit, strategic defaults declare to the lender that the borrower will no longer continue to make payments on their mortgaged property, thereby forcing the issue of foreclosure. Foreclosure, itself, can be a lengthy process, oftentimes spanning anywhere from a couple months to a few years. During this process, a borrower can shift their focus on extinguishing other more pressing debt. In this respect, strategic defaults prove to be a business-savvy move for many financially troubled families. 

Strategic defaults entail more than just simply breaking an agreement and can manifest in many forms. Theoretically, a debtor could abandon their high mortgage property for a cheaper property located on the same city block, (we’ve all seen properties in our own neighborhoods just like our own, being offered at significantly reduced prices) and the lender would have to accept the forfeiture. As a consequence, a family can get out of an unbearable financial situation while having their general life unaffected by the relatively simple move down the street. Although not as common, strategic defaults can also come in the form of short sales where people sell their properties to friends and family with the intention of buying the property back at a later time. Strategic defaults can spare home owners from crippling mortgages; however, they do not protect the forgiven debt from taxation! Often times, a strategic default may come as a consequence of a failed loan modification. 

 

How Strategic Defaults Work 

Subsequent to executing a strategic default, a debtor is often able to “erase” a significant portion of the debt. This erased portion amounts to the difference between the original mortgage and the price that the bank ultimately collects in a short sale or an auction, with the price more accurately reflecting the current market value of the sold property. However, these “savings” are subject to taxation. 

In the world of loan modifications, which are executed for much the same reason as a strategic default, the same rule of taxation applies. A principle reduction is often offered by a bank as part of a loan modification, instantly crediting a debtor a portion of the mortgage, thereby bringing the value of the note more in line with the actual market value of the property for which it is written. The difference between the new mortgage and the old is instantly subject to taxation. 

Under the banner of the Mortgage Forgiveness Debt Relief Act of 2007, debtors can shelter the money they had just saved via strategic defaults. If you or a loved one is considering strategic defaults, consult with a qualified tax professional immediately. It could mean the difference between filing a 1099 and a 982 tax form. There is a difference, only the IRS/State will not go out of its way to inform you. The benefits of strategic defaults are life changing; however, there are other forms of economic relief aside from strategic defaults. Loan modification is a more socially responsible solution especially if you are struggling with mortgage payments on a primary residence. If you are dealing with an upside down mortgage and are considering your options, don’t forget to consider the tax implications and be sure to consult with one of our tax consultants.