A Lender Can Not Obtain a Deficiency Judgment On A Purchase Money Mortgage, But Can Obtain A Deficiency Judgment On A Re-Finance. Currently, The Lenders Forgiveness Of This Debt Allows the IRS To Collect Taxes On The Forgiven Portion As Ordinary Income. The Mortgage Cancellation Relief Act Could Eliminate This Inequity.

by Anne Rand
© 2/01 Foreclosure News of NJ, Inc.

Every month, NJPForeclosures.com contains over 1,000 new foreclosure complaints. While each individual story is different, there is a common thread.

Something has happened to turn a person or families dream of home ownership into a nightmare. It may be a job loss, divorce, death in the family, illness or some life changing event which has prevented honest hard working people from making the mortgage payment.

Usually, when someone faces financial hardship, the credit card balances increase to just make ends meet. Groceries go on the credit card. At the end of the month, the food is gone but the bill is not. The unsecured debt increases. It gets harder to make the minimum payments.

When faced with a stack of bills and not enough money to pay for them all, what gets paid first? The mortgage. Eventually, one doesn't have enough to cover the mortgage.

Most homeowners do not contact their mortgage company at the beginning of a problem. If it is a "temporary" problem, they figure they will fix it. If it is a "permanent" problem, they tend to deny it. Unfortunately, they are digging a larger hole.

Frankly, addressing the problem up front with the mortgage company may provide some relief. Almost all homeowners facing financial hardship will not contact the mortgage company. Why? Simply put, it is very painful. Homeowners will not hear a pleasant voice on the other side of the phone, saying " it's OK if you don't pay us, we will except partial payments and you can make it up latter. Customer Service at a mortgage servicer is not set up to make it easy. Incidentally, customer service with any large company today is severely lacking. It seems as though technology has put a wall to distance us and make communication more difficult. Many times, one can not even speak to a real person.

But the simple truth is mortgage loans can be modified. No I don't mean re-financed. Refinancing is a new loan, with a new closing, attorney fees, appraisal, survey etc.

All the terms for a mortgage loan can be modified with the exception of the principal amount. Both the lender and the borrower must agree to a loan modification. While the amount of the debt can not be modified (this would trigger a tax and reduce the security of any subordinate debt), the interest rate and length (number of years to pay) or other terms can be changed. In practice, this is easier to say than to do. For the average homeowner in default it will be almost impossible to do. But for a homeowner who is just facing financial hardship and takes action with the mortgage company immediately, it is a viable alternative.

Why would a lender modify a loan? Simply put to keep your business. If the lender does not lower the rate (when rates are falling), then perhaps you will refinance somewhere else. The lender may prefer to keep the interest and servicing revenue rather than lose your business. However, if you are already in default, you are not paying. Not too much leverage for a modification.

Besides the interest rate, other terms of a mortgage loan to modify can include the length of the mortgage. Extending a 15 year mortgage to 30 years will significantly lower the monthly payment (but increase the amount of interest paid over the life of the loan). A 30 year mortgage can also be extended to a 40 year mortgage which would also lower the monthly payment. Other loan modifications could be to change the Due On Sale clause and make a non-assumable loan assumable, elimination of private mortgage insurance (PMI) or escrow for taxes and insurance (- must have at least 20% equity and may require an appraisal), or the Owner Occupancy requirement.

Considering loan modifications provide investors and home buyers with increased alternatives for financing properties. Proposing "workout agreements" (a form of loan modification) to a lenders can provide the financing for a foreclosure property. While a homeowner facing financial hardship will have a harder time convincing a lender to accept a "workout agreement", a third party with a fiduciary relationship to the troubled homeowner can provide the credibility to get the mortgage company's approval.

For example, If I am 3 months delinquent and request the amount in arrears to be spread over the next year, the mortgage company may agree or decline. The more proof I can offer that I can and will be able to pay will increase my chances of getting approval (i.e. proof of new job etc.).. On the other hand, if an investor (with good credit) offers to assume the loan in exchange for paying the arrears immediately and proposes a sales lease back to the original homeowner, this would lower the risk to the lender. The profitability of the above would depend on the detail (amount of equity, other terms of the mortgage and lease). The bottom line to the mortgage company is the mortgage modification would more likely be approved since the risk to the mortgage company is lower and a better alternative than foreclosure.

However, modifying a loan versus refinancing the same loan increases the risk to the lender. The initial mortgage one obtains for a property is a "purchase money mortgage". If you default on a purchase money mortgage, the lender can foreclose on the property but can NOT sue you for any shortfall. The shortfall is called a deficiency judgment.

On the other hand, when you refinance a loan, (or take a home equity loan) it is no longer a purchase money mortgage and the lender can foreclose on the home and obtain a deficiency judgment.

For example, the homeowner re-finances a home worth $100,000 with a $90,000 mortgage. A year latter, the homeowner can not pay the mortgage. The lender sends notice of Foreclosure.

The lender figures the home will bring $85,000 at a foreclosure sale. This is $5,000 less than what was borrowed and $4,500 less that what is owed. The lender knows it will cost additional money in legal fees, real estate brokerage fees, taxes and property maintenance to complete the foreclosure. The lender figures he will net $78,000. The lender will have a loss of $7,500.

The homeowner finds a buyer at $83,000 (with other financing) for a quick sale and the lender agrees not to foreclose and will not pursue the homeowner for the $6,500 unpaid balance on the mortgage.

The homeowner may breath a sigh of relief! The homeowner sees light at the end of the tunnel. He can make a fresh start. His credit will not be a damaged as a foreclosure on his credit report. But it will be short lived.

Why?

Under current law, the lender is required to report the amount of the debt forgiven to the IRS.

Now the federal government, the IRS, wants the troubled homeowner to pay ordinary income taxes on the $6,500 of debt forgiven by the bank.

The troubled homeowner has lost his home, he has no equity and he was responsible about taking steps to remedy the situation and the IRS wants to get blood from the stone!

There is hope on the horizon!

The Mortgage Cancellation Relief Act will relieve this burden of paying taxes on debt forgiveness. A similar bill has already passed in the House. New Jersey can thank Rep. Robert E. Andrews (Democrat) for sponsoring the House version. It looks promising that it will also pass in the Senate.

Once the bill becomes law, it will eliminate the unfortunate surprise many homeowners in foreclosure face with workout agreements and the tax consequences of the forgiveness of debt.

This is a good thing for foreclosure buyers who look to make deals with troubled homeowners. Once a workout agreement or short sale is signed on the bottom line, there will be no nasty IRS surprises. It is obvious a good thing for the homeowner in foreclosure.

Even after the bill is passed, investors and home buyers must remember the difference between the purchase money mortgage and re-finance. The lender can not pursue a homeowner for a deficiency judgment when it is a purchase money mortgage. One can lose the home and that is it. The lender can pursue the homeowner for a deficiency judgment for a home equity or refinance loan. Therefore, one can lose the home and have a judgment owned for the difference. The only difference the pending bill has made is, IF the lender does not pursue the homeowner for a deficiency judgment, the IRS won't tax the homeowner on the forgiveness of debt.

Will passing the bill increase the incentive for lenders to pursue the deficiency judgment rather than forgive it? I don't know!

For now, I'll keep my purchase money mortgage!