Strategic Default Options For Underwater Homeowners

Q: Do you ever address strategic default on rental property? I owe $135,000 and the property is worth only $65,000.

A: Strategic default – hardly any topic in real estate raises hackles quite like this one.

If your property is worth less than you owe, and whatever reason, you can’t get a loan modification that will make it affordable to carry the property until prices normalize, you have several lousy options.

First, you can try to sell your property in a short sale, in which the bank would have to agree to accept less than the mortgage amount. The difference between what you owe and what the property sells for is treated by the IRS as a gift from the mortgage lender to you. The debt is forgiven (you want the lender to sign off on this, so you don’t have a debt collector coming after you down the road), but a 1099-C is issued for the difference, also known as the deficiency.

If the short sale is a primary residence, the IRS will not tax you on this deficiency, as long as the property sells through the end of 2013. However, if the property is a second home, vacation residence or investment property and you do a short sale, the IRS will treat the deficiency as additional income to you, and you will be taxed on the amount at your marginal tax rate.

That can get pretty expensive. If your property is worth $65,000 and you owe $135,000, that’s a deficiency of $70,000 to start, and then you have to add in the other costs of sale, such as the broker’s commission and transfer taxes. You could easily wind up with a deficiency of $80,000. That’s a pretty high income number on its own, and if you earn $60,000, the IRS will treat your income as if it were $140,000, pushing you into a fairly high tax bracket.

Your second option is a deed-in-lieu of foreclosure, in which you simply hand back the property to your lender in exchange for releasing you from your debt. In many areas, this works easily and the property gets retitled. But in other areas, lenders are resisting handling a deed-in-lieu of foreclosure simply because they don’t want the property back on their books.

If you pursue the deed-in-lieu of foreclosure option, make sure the lender accepts the property and the paperwork gets recorded properly.

What do you do if you have the money to pay your mortgage, but your property is so severely underwater that you don’t believe it will get right side up for twenty years or more?

Strategic default is a term used to describe borrowers who decide to simply stop paying and walk away from their mortgage obligations even when they have the ability and can afford to pay their mortgages. While this is a perfectly legal and a recognized business strategy, it provokes great consternation among many other homeowners who believe that those borrowers who opt for a strategic default are somehow morally bankrupt, or don’t care about the real estate valuation problems they’re exacerbating for others in the neighborhood.

Whether or not you are a fan of strategic default, the numbers of folks walking away from severely underwater homes appears to be growing, especially in markets where the number of foreclosures is increasing and home prices are dropping rapidly.

According to a new survey by FICO, 46 percent of risk professionals surveyed expect the number of borrowers choosing strategic default to increase in 2012 over 2011. And almost half of all homeowners with a mortgage say they would walk away from their home if home values continue to fall, according to an online poll from Housing Predictor.

The risk with a strategic default is that the lender would chase you to pay off the deficiency. And, you’ll have a significant hit on your credit. But if this is the right choice for you, then make it – with your eyes wide open. And in some states, the lender’s only recourse against you is to sell the home and use the proceeds to satisfy the amount owed, but the lender can’t go after you for the deficiency.

Hope this helps.

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5 Responses to Strategic Default Options For Underwater Homeowners

  1. M.Z. says:

    I was wondering why you didn’t mention bankruptcy (with property surrender) as an option? While not applicable to everyone’s situation, especially if multiple names are on the mortgage, I found it to be an amazing option on my underwater condos. No fear of getting 1099’d, any default judgement is considered part of the BK estate, added benefit of dumping some credit card debt, etc. Post BK7, I’m living mortgage-free, not paying the property taxes, collecting rent on my rental property, and can still hire a foreclosure defense attorney to prolong the process, if I so choose. (Why make it easy on the banks who wouldn’t refinance or modify my mortgage when I needed help?) With BK, I was able to turn the tide in my favor, the foreclosure case on my primary residence is in limbo, and I anticipate a cash-for-keys scenario.

    With BK, I have nothing to gain by attempting a short sale or deed-in-lieu and Chase & Freddie Mac are over a proverbial barrel…

  2. linder says:

    You didn’t address what I believe is a serious lapse of ethics when landlords walk away: They keep collecting rent! Is it fair for them to keep collecting rent on a property they’re sending into foreclosure, which could take years, and do you really think the landlord will maintain the property during that time? The tenants lose big time; they pay full freight, repairs don’t get done, and one day they find their abode has been sold out from under them. They don’t get a nice couple of years to live rent-free; if they stop paying they typically have 3 days to pay or get evicted. And no policymaker talks about keeping them in their home, do they?

    • Samuel J. Tamkin says:

      You make a good point on homeowners turned landlords that pocket rental money, don’t pay their lenders and then allow properties to go into foreclosure.

  3. Andree says:

    How does a HELOC figure into the strategic default scenario? Is bankruptcy the only way out?

  4. Jeff says:

    I have a rental, my former prirmary residence that I was unsable to sell, which is $75K underwater and I’m having difficulty renting it. I rented it in year one, but that tenant left and even at lower price I’m getting little interest. I was told by a lawyer that if I short sell it, as the article mentions, as an “investment property” I will have to pay taxes. That could amount to more than $20K. I can’t afford that. But neither can I afford to make the mortgage payment on the rental. I was already taking a $200 a month loss on just the rental price. I have a 1st and 2d mortgage on it. If I let it go into foreclosure, will I have to pay taxes the same as I would on a short sale? Would a BK wipe it out entirely? I’d be happy to keep taking a loss and keep it rented as I don’t want negative credit history. But I simply can’t afford to pay it if it sits empty.

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