SOME RUMORS AND TRUTHS ABOUT MORTGAGE
MODIFICATIONS AND FORECLOSURES
© Jorge I.G. del Valle, Esq.2009
RUMOR: I can sue the bank and walk away with my property without having to pay the rest of my mortgage.
TRUTH: Yes. However, this is the rare exception not the rule.
Loan closing violations or materially flawed loan documents may result in the bank losing its in rem lien (i.e., a mortgage), leaving the bank with only an in personam lien. Why is this significant? Because in personam liens can be wiped out in bankruptcy but in rem liens cannot.
Therefore, if the borrower wins a lawsuit against the bank to rescind the mortgage lien due to loan violations or defeating the bank’s claim of a valid mortgage lien due to seriously flawed loan documents (i.e., eliminating the bank’s in rem lien) the borrower can then file for bankruptcy to wipe away the resulting in personam lien.
However, borrowers’ expectations should be kept realistic because the fees and costs to litigate many of these claims to fruition are often prohibitive to a borrower, particularly one who is already having trouble paying a monthly mortgage.
RUMOR: Modifying my mortgage will hurt my credit score.
TRUTH: It depends. Even if modifying your mortgage could potentially hurt your credit, the resulting credit damage is not as bad as you may think and is not as bad to your credit as a short sale or foreclosure. Anytime you do not pay a debt timely, your credit score is likely going to drop. However, in the event of a successful modification, you are often repaying some or the entire late and/or unpaid amount, which will either restore or help start the immediate repair of your credit. Further, if you are successful in modifying your mortgage without missing a monthly mortgage payment, there should be little to no impact on your credit score.
RUMOR: Banks are offering principal balance reductions on “upside down” loans.
TRUTH: Yes. In some cases banks are reducing principal balances but this is the exception, not the rule. Borrowers should be mindful that from the banks’ perspective, writing down the principal balance to what the property may be worth is akin to a foreclosure in that the bank takes a loss, but unlike a foreclosure sale or short sale, the bank does not get any proceeds from the sale of the property (i.e., there is no cash infusion to the bank). Considering the borrower also keeps ownership, possession and any appreciation in value when the property is sold years downs the road, there is little to no incentive for the bank to consider this option.
The first choice for many (and perhaps most) banks is to simply grant the borrower a limited forbearance and then work out a repayment plan for the late and unpaid amounts. Many banks are adding the late and unpaid amounts to the loan and lowering interest rates in order to reduce the monthly mortgage payments. Additionally, in some cases, the banks will also consider extending the term of the loan (from 15 year to 30 years or from 30 years to 40 years) to further reduce the monthly mortgage payments, all in an effort to achieve a performing loan (i.e., where the borrower is able to make regular monthly payments again).
Significant principal reductions are more often experienced in situations involving holders of second mortgages when the holder of the second mortgage is convinced that the sales proceeds of the property (if there were a foreclosure) would leave little to nothing for the second mortgage holder after the first mortgage is paid down, except for an in personam lien, which as noted above, can be discharged in bankruptcy. Facing the real possibility of getting none of its principal repaid, second mortgage holders will in many cases open up to a significant reduction in the principal balance. A significant reduction and/or elimination of the second mortgage payments often will be enough to allow the borrower to: (a) continue paying the first mortgage; (b) facilitate a modification of the first mortgage; or (c) facilitate a short sale.
RUMOR: Once the bank forecloses or accepts a short sale, I no longer owe anything in connection with the mortgage.
TRUTH: This result is possible. However, if not managed or addressed properly at the time of foreclosure or short sale, the most likely to end up knocking on the proverbial door looking for money from the borrower will be either: (a) the bank (or its designated collector); or (b) the IRS.
Borrowers should be mindful that after a foreclosure sale or short sale banks essentially have three choices: (a) sue the borrower for the deficiency (i.e., the portion of the mortgage loan not covered by the proceeds of the sale of the property); (b) cancel/forgive the deficiency and issue a 1099 to the IRS; or (c) do nothing.
If a bank opts to sue for the deficiency, it can wait as many as five years after the default to do so. Once a deficiency judgment is obtained, it can survive for as long as 20 years. Therefore, the ramifications of a foreclosure or short sale can potentially haunt a borrower for the next 25 years of their lives. Because obtaining a deficiency judgment and subsequent collection efforts are an added expense, at least some banks will sell their right to seek a deficiency to a collection company, which is more efficient at collecting debts (and often more aggressive).
Instead of seeking a deficiency, a bank could opt to cancel or forgive the deficiency and issue the borrower a 1099 form, which results in taxable income to the borrower. Therefore, unless the borrower qualifies for one of a few available income tax exemptions, the borrower will be obligated to pay the IRS the income tax due on the additional “income” resulting from the deficiency. By way of a simple example, if the mortgage balance is $350,000, the property’s value is $150,000 and the borrower’s regular yearly salary is $50,000, and the bank opts to cancel the $200,000 deficiency (i.e., $350,000 less $150,000), then the borrower is subject to paying income tax on $250,000 of income (i.e., $50,000 yearly salary plus $200,000 of “income” because the bank forgave the deficiency).
Lastly, the bank could opt to do nothing and simply leave the borrower alone. You might have read or heard some experts suggest many banks will do just that. However, considering banks are currently overwhelmed just trying to get through all the foreclosures, short sales, and loan modifications and also considering banks have as long as 5 years to seek a deficiency, the guess here is that as long as the borrowers are not using their leverage to force the bank to make a selection sooner, the banks are going to wait as long as practicable before making their decision on whether to (a) do nothing, (b) seek a deficiency (or sell that deficiency to a collection company) or (c) forgive the debt (and issue a 1099). Therefore, many unsuspecting borrowers who have already gone through a foreclosure or short sale of their property and ignored or did not successfully negotiate these issues could very well find either a bank, collection company or the IRS knocking at their door sometime in the next few years.
Note: There are potential tax consequences involved in the cancellation or forgiveness of debt when a bank writes down or forgives all or portions of the principal balance and borrowers should consult a professional tax consultant (i.e. accountant or tax attorney) to address these consequences.
Amaury Cruz & Associates
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