It’s Friday evening and I am just about to wind down when the phone rings from one of our tenants. Apparently, the Sheriff has just posted a notice on their door with several documents. The tenant understands one part…the word “foreclosure”. Immediately I realize that our owner has not been making mortgage payments and now the lives of their tenant is about to be turned upside down.
I understand every foreclosure has its own unique reasons. It still seems wrong to take a tenant’s rent money and not make sure the obligations concerning the mortgage are kept current. In fact, over a year ago we added language to our management contract to specifically address mortgage payment default as a term of cancellation. Within this term of the agreement, the owner permits us to immediately locate a new home for the tenant. I understand the foreclosure process well enough to not want to gamble with how long a tenant may be able to live in a property when this legal action has been taken.
What about the owner though? I wonder if the owner has considered the cost of foreclosure? For that matter, the cost of a short sale? This is a complicated tax matter, better left to be addressed considering each person’s individual circumstances, but the IRS is likely to still demand payment of taxes on the recapture of depreciation deduction (approximately 25% of the amount previously depreciated), capital gains (state and federal), and the cancellation of debt (assuming the court does not provide the lender a judgement to pursue the owner for a deficiency). Please note the Mortgage Forgiveness Debt Relief Act does not apply to investors renting a property. An investor might be able to take advantage of some of the protections of this law if they can prove they actually lived in the home for two of the past five years. Again, these are matters for your tax professional. If you do not have one, now is the time to get one on your team.
In addition to the potential tax hits, a foreclosure will destroy your credit. I have read certain people think that somehow when the housing market recovers lenders are going to look at this period of time with more lattitude given to those who experienced a foreclosure. I find that hard to believe, particularly when every event in the credit market has made it harder to get any kind of financing. Assume that you will be excluded from the traditional housing finance market for 5-7 years. This also is just the affect on borrowing for housing. Expect issues with car loans, credit cards, and any other situation requiring a credit report.
Lets return to the property where the tenant was making their rent payments on time. In this case I learned the owner had a monthly deficiency of $250 (rent was not covering his payment). Additionally, he did not wish to make some needed repairs to the structure based on an estimated drop in value. Yet, assuming a forgiveness of the debt and depreciation recapture, he was going to assume a new obligation with Uncle Sam that exceeded the next two years of rent deficiency! Nobody had discussed the tax side of the foreclosure coin with him. He just knew that he did not want to keep losing money every month.
Losing money every month or having the IRS breathing down your throat for their taxes? It is your decision to make. I just want our clients to understand the potential ramifications if they decide to “let their property go.”
