Q. What exactly does a deficiency waiver mean?
A. A waiver of deficiency means that the mortgage company has agreed not to sue you for the unpaid balance that may remain after the home is sold (whether via a foreclosure sale, short sale or deed in lieu of foreclosure). While this sounds good and will also result in more favorable credit due to a zero balance being reported with the credit bureaus, there are possible tax consequences.
Q. Why is this important now in 2014?
A. The Mortgage Debt Relief Forgiveness Act previously provided a waiver for the cancelled debt taxes for most homesteaded properties; however, this Act unfortunately expired as of December 31, 2013. The only waiver in place currently is insolvency.
Q. Are my risks of receiving a 1099c the same for a short sale vs. a foreclosure sale?
A. You are more likely to receive a 1099c in a short sale than a foreclosure sale. This is because in a short sale, there is already an agreement that there is a deficiency and the amount is already determined by the sale of the property. Many clients feel that a short sale is better for one’s credit and will often allow them to qualify for a new home purchase using governmental financing quicker.
Q. Are my risks greater if I agree to a deficiency waiver in a consent judgment?
A. Perhaps. We really don’t know yet. Clients have not been receiving 1099c’s after a foreclosure sale resulting from a consent judgment with deficiency waiver, but that may change at any time now that the Mortgage Debt Relief Act expired. Clients can assert that while they obtained a deficiency waiver from the lender that does not necessarily mean that they agreed that there even was a deficiency and the lender has to prove the actual amount of that deficiency as well as an attempt to collect it. However, it is likely riskier than simply allowing the case to proceed to trial without a waiver. All clients should consult with a tax advisor before agreeing to a deficiency waiver, particularly clients with other assets who would not be protected by an insolvency defense.
Q. What is the insolvency defense to the tax liability for cancelled debt?
A. The IRS provides a worksheet that you can fill out and if you do not have assets (401k, IRAs and other retirement accounts, cash, equity in another home or business etc.) that exceed your liabilities, you would likely receive an insolvency waiver for the cancelled debt taxes. Retirement accounts such as 401ks, IRAs are protected in a bankruptcy. Clients may also have carry forward losses that could help or other tax offsets.
Q. Can bankruptcy eliminate the tax liability?
A. Yes. A local tax attorney has advised that if the bankruptcy is filed before a 1099c is issued, then any tax liability for cancelled debt is extinguished. If a bankruptcy is filed the same tax year as the 1099c is issued, the result is far less certain and the client should speak with a tax advisor. Generally taxes are only dischargeable in bankruptcy after they age at least three years.