Are You a Rental Property Owner Facing Foreclosure? Read on…..

I’m getting phone calls every other day from investors facing foreclosure on their rental properties. What are the tax consequences of such an occurence? They can be costly! The Mortgage Forgiveness Debt Relief Act does not cover rental properties. What this means is that when the bank forecloses on your investment property, you may likely be issued a 1099C form. (Your tax liability depends on whether you have a recourse or non-recourse loan. Recourse means you, the borrower, has personal liability for the loan, in addition to the risk of losing your real property. ) The IRS will also recieve a copy of the same form. This form shows the amount of “cancelled debt” that will be considered income to you. In other words, if your mortgage on your rental property was $200,000 and the bank was only able to sell it for $120,000, the difference of $80,000 is now considered cancelled debt income to you. You must add this amount on your tax return and be taxed on an additional $80,000 income. OUCH!

I want to propose an idea if you are an investor who unfortunately finds him/herself in this situation. It’s called a Deed in lieu of foreclosure.

A Deed in lieu of foreclosure is a deed instrument in which a mortgagor (i.e. the borrower) conveys all interest in a real property to the mortgagee (i.e. the lender) to satisfy a loan that is in default and avoid foreclosure proceedings.
The deed in lieu of foreclosure offers several advantages to both the borrower and the lender. The principal advantage to the borrower is that it immediately releases him/her from most or all of the personal indebtedness associated with the defaulted loan. The borrower also avoids the public notoriety of a foreclosure proceeding and may receive more generous terms than he/she would in a formal foreclosure. Another benefit to the borrower is that it hurts their credit less than a foreclosure does. Advantages to a lender include a reduction in the time and cost of a repossession, and additional advantages if the borrower subsequently files for bankruptcy.

In order to be considered a deed in lieu of foreclosure, the indebtedness must be secured by the real estate being transferred. Both sides must enter into the transaction voluntarily and in good faith. The settlement agreement must have total consideration that is at least equal to the fair market value of the property being conveyed. Sometimes, the lender will not proceed with a deed in lieu of foreclosure if the outstanding indebtedness of the borrower exceeds the current fair market value of the property. This is an important point. If you have equity in this property, no matter how small, you may want to contact your lender to see if this is something you can work out. Other times, lenders will agree since they will end up with the property anyway and the foreclosure process is costly to the lender. Be sure that the lender agrees, in writing, to forgive any deficiency (the amount of the loan that isn’t covered by the sale proceeds) that remains after the house is sold.

Because of the requirement that the instrument be voluntary, lenders will often not act upon a deed in lieu of foreclosure unless they receive a written offer of such a conveyance from the borrower that specifically states that the offer to enter into negotiations is being made voluntarily. This will enact the parol evidence rule (get it in writing!) and protect the lender from a possible subsequent claim that the lender acted in bad faith or pressured the borrower into the settlement. Both sides may then proceed with settlement negotiations.

Neither the borrower nor the lender is obliged to proceed with the deed in lieu of foreclosure until a final agreement is reached.

For you New Yorkers out there….the Home Equity Theft Prevention Act has created some confusion regarding this frequently-used method of settlement. It is unclear whether HETPA applies to deeds in lieu of foreclosure since there is no clear exclusion as there is for a referee’s deed, for example. The 2-year right of recission is not a risk that banks or title insurers are comfortable with, especially given the complexities of compliance, so many banks and title insurers in New York are not willing to work with deeds in lieu.

Please feel free to contact E-File Florida at 954-583-8534 or visit us on the internet at http://www.efileflorida.com/ for more great tax tips and articles.

IRS CIRCULAR 230 Required Notice – IRS regulations require that we inform you as follows: Any Federal tax advice contained in this communication (including any attachments) is not intended to be used and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction as tax related matter(s).