Monday, October 15, 2012

Strategic Default Best Practices: Consider The Tax Implications

In this article we will explore how to properly analyze a strategic default in connection with any potential tax liability. This is the first article in our new series: Strategic Default Best Practices

Many homeowners who have strategically defaulted now recognize it can several years for a lender to collect a debt or to foreclose on a property. In fact, many homeowners continue to live in and/or rent their property while strategically defaulting.

It stands to reason that a homeowner who strategically defaults intends to be in a better financial position.  The homeowner has not made mortgage payments for several years while living in and/or while renting part or all their property. What a paradox?  By not making mortgage payments a homeowner can potentially improve their financial profile. In fact a properly implemented strategic default can create a better financial future for you, your family, or your business. Keep in mind that maintaining a good credit score is not possible when implementing a strategic default. Thus a “credit score" is not an important financial consideration during a strategic default. The primary goals of a strategic default are to protect and increase cash flow, to protect and increase savings, and to protect and preserve wealth/assets; all with the aim of reducing or eliminating the total debt and/or any tax. 

There is no free ride when it comes to not paying a debt. In our book, Strategic Default: How To Create A Better Financial Future for You, Your Family, or Your Business we outlined the principle "Debt Is Similar to the Physics Principle of Matter and Energy". There is a principle in physics that matter and energy can neither be created nor destroyed; they can only be rearranged. Debt follows the same lines. Once debt is created it cannot be destroyed unless it is restructured and resolved. Therefore, if a debt is not settled or resolved, then the debt will remain as long as the creditors are legally allowed to chase you for it. For example, a money judgment can last for 20 years in New York. Original lenders and 3rd party debt collectors will always attempt to collect unpaid debts plus interest and penalties. The tax authorities (IRS and states) will always attempt to collect taxes on forgiven debt and/or rental income. Keep in mind that the Mortgage Forgiveness Debt Relief Act ("MFDRA") provides a tax exemption for forgiven debt in certain circumstances. However, the MFDRA is set to expire December 31, 2012 unless the federal government renews the law. 

There are other risks of a strategic default. The primary risks are: 
  1. Deficiency debt can lead to a deficiency judgment. 
  2. A property can be lost in a foreclosure action.
  3. Lower credit score. 
  4. Exposure to aggressive debt collection tactics. 
  5. Personal liability for unpaid taxes, utilities, or other property related expenses. 
  6. Government action against homeowners that strategically default. For example Fannie Mae may not allow home loans to individuals who strategically default. Recently it was reported that the Federal Housing Finance Agency ("FHFA") intends to aggressively go after individuals who strategically default on a government insured home loan. However a FHFA official released a statement claiming that it will not be the policy to seek out people who strategically default. The bottom line: The government has its eye out on strategic defaulters. 

Simply read all of the articles on this website to learn about the various risks in detail.  

The decision to strategically default involves a proper evaluation of the risks and the reward in order to obtain the best return on the additional cash. So how does a homeowner maximize their return from a strategic default? 

In order to achieve the maximum financial benefit of a strategic default, a homeowner must learn “Strategic Default Best Practices”.  A homeowner must successfully implement the best available practices to achieve an optimum strategic default. An optimum strategic default occurs when the homeowner obtains a higher rate of return from the money not used for debt payments then the rate of return obtained from the same money that could be used to make the debt payments. The homeowner must learn how to maximize the financial gain and minimize the financial penalties and costs.

So let's talk about Strategic Default Best Practices as it relates to potential tax obligations. There are 3 main principles:  

  1. The cash not used for debt payments and/or the cash collected for rents are normally considered income by the IRS and/or state tax authority.  
  2. A forgiven debt is normally considered income by the IRS and/or state tax authority.
  3. A homeowner must always seek the advice of an accountant or tax professional prior to the implementation of a strategic default in order to determine any tax liability that may arise from the income generated and/or collected by a strategic default.  

Let's look at a few examples:

Example 1. A homeowner who strategically defaults on an investment property earns income from a rental tenant. This homeowner is collecting $1800 a month in rent while not paying the mortgage. The homeowner is responsible for paying the utilities, real estate, taxes, insurance, repairs, and possibly home owner association fees. Let’s estimate that after all deduction for expenses the homeowner is earning $1200 per month or $14,400 a year. In addition to all other types of income earned by the homeowner, the homeowner has earned an additional $14,400 in yearly rental income from her strategic default. 

Example 2. Using the information from the example above let's say the homeowner’s regular mortgage payment is $3000 per month or $36,000 per year. In addition to collecting $14,400 in yearly rental income this homeowner has increased their yearly disposable income by $36000. Keep in mind that if this homeowner made her $3000 monthly mortgage payment, she may be entitled to a mortgage interest tax deduction. Since she has decided to strategically default she is not entitled to the mortgage interest tax deduction.  Instead she no longer makes the $36,000 yearly mortgage payments and she collects $14400 in yearly rental income. In addition to all other income earned by the homeowner described in Examples 1 & 2, she has earned an additional $50,400 ($36,000 + $14,400) in yearly income through the non-payment of her mortgage and the collection of rental income. 

Example 3. A homeowner who strategically defaults on a $200,000 second mortgage later settles for $30,000. In this scenario, the homeowner may receive a 1099 for the $170,000 ($200,000 - $30,000) in forgiven debt. In fact, if the original $200,000 debt rose to $250,000 due to unpaid interest, fees, and penalties then a $30,000 settlement may produce a 1099 for $220,000 ($250,000 - $30,000). In addition to all other income earned by the homeowner, she has earned an additional $170,000 to $220,000 from her strategic default. Once again keep in mind that the MFDRA provides a tax exemption for forgiven debt in certain circumstances. However, the MFDRA is set to expire December 31, 2012 unless the federal government renews the law. 

In all 3 of the above examples the homeowner has a potential tax liability for the income gained from collecting rent, from the non-payment of mortgage, and/or from the forgiveness of a debt. The earned income can increase her gross income for state and federal tax purposes. 

The best practice in this situation is to consult with a tax professional prior to implementing a strategic default. So, for example, let's say our homeowner learns from her accountant that her increased tax liability for the first year will be $15,000 for the additional rental and mortgage payment income and a one-time tax liability of $40,000 for the forgiven debt. 

A homeowner properly utilizing Strategic Default Best Practices to determine potential tax liabilities should take the following steps:

  1. Calculate the income gained from employing a strategic default.  The sources of income can come from rents or debts that you do not have to legally pay. You will see an increase in income by not making mortgage payments. 
  2. Contact an experienced accountant and review the income determinations. Ask the accountant to provide estimates of your tax liability.
  3. Once you know your estimated tax liability determine if it makes financial sense to strategically default.  
Of course the decision to strategically default does not end with a tax analysis. There are many other factors that are unique to each individual. This is just one step of the many steps necessary to
properly execute a strategic default. 

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