Blissful, young newlyweds on a let’s-build-a-nest high, you and your spouse purchased a half million dollar house with zero down on a thirty year mortgage with a balloon payment. Ten years later, the bliss has soured and you both want out, but you’ve barely made a dent in the principal. With home foreclosures having been at their highest, many couples face this predicament. Now what?
If you cannot repay your mortgage loan, your lender may begin the foreclosure process. If you face a foreclosure, contact your lender and request a meeting immediately.
At the meeting, discuss what options you have to delay the foreclosure. These may include forbearance, refinancing, a longer redemption period in the event of foreclosure, a new payment schedule, and a short sale. Be proactive. Do not wait for a foreclosure notice to contact your lender or hope that your divorce will shift the debt to your spouse. Usually, it will not. Explain your legal and financial problems to your lender, and ask for reprieve. Most lenders are willing to work with you if you are sincere and in good faith negotiate a repayment plan because lenders would rather have an income stream than an empty house.
Talk to your lender, your financial advisor and your attorney about a short sale. In a short sale, the lender agrees to accept less than the borrower’s mortgage indebtedness when the borrower sells the property to a third party in an arm’s-length transaction. Lenders usually agree to short sales to avoid the costs of foreclosure and having a large inventory of empty, unsellable homes.
However, short sales come with their own costs.
First, as a matter of contract law, a lender may pursue a deficiency if the short sale approval is not conditioned on the lender waiving the deficiency. Therefore, be sure to condition any short sale plan submitted to your lender for approval on the lender waiving any deficiency.
Second, the short sale approval process is long and tedious; you and your potential buyer must be willing to wait. Large lenders have short sale packets for use. They include forms for, inter alia, comparative market analyses and brokers’ price opinions, hardship letters, financial disclosures, authorizations to release information, listing agreements, and proposed sale terms.
Third, if the lender does approve the short sale and waive any deficiency, the forgiven debt may trigger income tax liability. The lender must send the borrower Form 1099-C, Cancellation of Debt, to indicate the amount of debt forgiven. If the debt was for a principal residence, under the Emergency Economic Stabilization Act of 2008, until 2013 borrowers may exclude the forgiven debt from gross income for federal tax purposes. There is no dollar limit on the exclusion if the principal balance at the time the lender forgave/cancelled the debt was less than $2 million for a couple filing jointly or $1 million for a borrower married but filing separately. Otherwise, the debt may be includable in gross income for tax liability calculations.[1]
If you award the home to one spouse, be sure to state what liabilities follow the house. For example, awarding the home does not, absent more, affect each spouse’s liability on the home mortgage. For example, in Marrow v Marrow, 118 NC App 332; 454 SE2d 853 (1995), the North Carolina Court of Appeals held that a deed to a spouse “assuming the mortgage” did not mean the spouse agreed to relieve the other spouse from liability on their home mortgage because (1) the spouse took no further action (e.g., by making full payments) and (2) the parties’ decree awarded the house to the spouse but required each of them to pay the mortgage until the house sold. Require the taking spouse to refinance the mortgage into the spouse’s name immediately.
If refinancing within the year is impracticable, impose on the spouse a continuing duty to apply for refinancing in good faith until successful and, in the interim, to hold the non-taking spouse harmless for any mortgage default and the costs thereto (e.g., interest). State who is responsible for property taxes, insurance, homeowners’ association fees and any other liabilities until the home is refinanced or sold. State what recourse the non-taking spouse has against the spouse in the event of default, such as liquidated damages, mandatory attorney fees and/or contempt.
[1] Tax liability for short sales is in addition to the tax consequences in IRC 1041 (for sales and other dispositions incident to divorce) and IRC 71 (for includability/deductibility of certain periodic payments in a divorce decree or other written separation agreement). These tax issues go beyond the scope of this article. You should contact a tax attorney and/or your financial advisor for a thorough assessment of the tax laws applicable to you. IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, be advised that any federal tax advice contained in this article was not intended or written 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 or matter addressed herein. Always consult a specialist for thorough tax advice.