Walking away from your mortgage – Risk or reward?

An idea has been making the rounds. That underwater borrowers – owners whose homes are worth less than what’s owed on their mortgages – should stop making payments and let their lenders foreclose.

The thinking is this: because house prices in some markets have declined so steeply it will take years for property to be worth what it was before the economic meltdown, many owners – even those not financially strapped – don’t see the point of continuing to fork out monthly payments, especially if they don’t intend to stay in the house long-term.

But does this so-called ‘strategic default’ really make sense?

On the plus side, the strategy of getting out from under heavy debt and not throwing good money after bad amounts to pulling the plug on a lose-lose situation. Given the months on end it takes lenders to foreclose and repossess property, owners can stay in their houses rent-free while padding their bank accounts with money otherwise thrown down the rat-hole.

Sounds good on the surface. Trouble is, strategic default has serious consequences.

Deficiencies

Depending on the state, the defaulting owner may have to pay the deficiency – the difference between the amount owed and the price brought at the foreclosure sale. So, if you have to pay the balance anyway, what’s the point in walking away? Sure, the deficiency might be discharged in bankruptcy, but not everyone is that far in the hole. Bankruptcy, remember, is only for the insolvent – those who owe more than they own.

Keep in mind too that state foreclosure laws vary, especially about whether lenders can go after borrowers for deficiencies. So, persons contemplating a strategic default need to know what their state allows.

Painting with a broad brush, most states east of the Mississippi (Indiana among them) allow lenders to collect deficiencies, while many western states do not. It comes down to state law and the papers signed at closing (mortgages in the east, deeds of trust in the west).

To foreclose mortgages, lenders have to go to court. When that happens, borrowers usually have the right to redeem (buy the property back) and lenders can go after the deficiency. Deeds of trust, on the other hand, allow lenders to take property back without going to court, the trade-off being borrowers can’t redeem but don’t have to pay the shortfall. Then again, some states’ procedures are a hodge-podge of both methods.

To find out what each state requires, check out www.foreclosurelaw.org.

Credit scores

Anytime a debt isn’t paid on time or in full, a borrower’s credit score will suffer. So whether a borrower is selling short (the lender agrees to take less than owed), or losing the house in foreclosure, or filing bankruptcy, the borrower’s credit score will drop.

Some strategic defaulters rationalize a credit score hit because they don’t plan to buy another house. They’re over home ownership and perfectly happy to be renters. But credit scores can keep rearing their heads. Landlords run credit checks. So do car dealers. And interest rates on credit cards may be higher as credit scores plummet.

Taxes

Thanks to the Mortgage Forgiveness Debt Relief Act of 2007, the deficiency forgiven by the lender is not taxable as income to the borrower who has defaulted and is being let off the hook. (The IRS considers debt forgiveness the same as receiving cash, and therefore taxable.) This law provides welcome relief but is temporary, applying to forgiven debt only in years 2007 through 2012. And, it’s limited to debt on owner-occupied principal residences, provided the debt was incurred to buy the house, build it, or remodel it (or to refinance that debt). In other words, debt pertaining to a refinance to take out cash to, say, buy a car isn’t covered. For more on the MFDRA, see my September 27, 2010, blog, which covers IRS Form 1099-C (‘C’ stands for cancellation) that lenders will send forgiven borrowers and IRS Form 982 that borrowers must file with their federal return (even if the cancelled ‘income’ is excluded).

Remember too, the MFDRA is a federal law applying to federal income tax. State income tax laws aren’t affected by it. So, unless a state has enacted a similar law, state income tax on the forgiven debt may still apply.

- Morrie Erickson