By Adam Baumli, JD.
If you happened to be negatively affected by the Economic Recession, you lost some or all of your income, your house decreased in value, you ended up losing your house, and your nightmare does not end there. For many, this economic recession has been one long nightmare with different dreams that cause sleepless nights, frequent worry, and endless frustration. Some people end up losing their home. There are two ways to lose your house: you can lose it through foreclosure, or you can short sell your house.
A short sell is where you sell your house for less than you owe on the mortgage. Many banks will agree to these sales and then forgive the difference of your loan. In other words, you walk away from the house, but you make no more payments even though you still should owe the difference between the mortgage and your sale price. For example, you bought a house for $200,000.00 and made payments for five years and you still owe $190,000.00. However, due to economic reasons, your house is now worth $170,000.00. When you short sell the house, the new buyers purchase it at a price that it’s worth, $170,000.00. Now, the bank collects the $170,000.00, but is still owed another $20,000.00. In most short sells, they forgive that debt. You receive no bills for that amount. This is one of the best things that could happen to you if you end up in this situation. For most people, they believe the nightmare is over. Their credit may be trashed, but they have no more creditor phone calls and they don’t have to go to court. As long as they can afford rent somewhere, they have a roof over their head. However, the nightmare has not ended, you can expect a letter from a major creditor at the beginning of the following year and this creditor doesn’t mess around.
A foreclosure is when you fail to make your mortgage payments and the bank sells the property auction style on the steps of the courthouse. Your name ends up in the paper, it’s embarrassing, you are evicted, it’s embarrassing, and it’s on your credit report, it’s embarrassing. This case operates similar to a short sale; the house is sold for an amount around what it is worth. The difference is then passed off to you as unsecured debt. Some banks will forgive the difference, some don’t. You may end up receiving creditor phone calls for some time, then be sued and dragged into court, it’s embarrassing. For some people, the bank forgives the unsecured debt amount. Similar to the case above, you can expect to receive a letter from the major creditor after the turn of the year.
Now, before we go into creditor, one may ask himself, why would a bank forgive the unsecured debt? Simply, it is because that debt amount is an above the line deduction, a business expense. This debt can be used to zero out the corporate income for the year. In other words, when business is booming for banks, short sales and foreclosure forgiveness is at an all time high. For a majority of the cases, it is not like the bank is ever going to receive that money anyways. Banks have a pretty good idea who can pay and who can’t and they will use their guidelines to decide who to forgive and who to sue.
The giant creditor in the dark is the Internal Revenue Service, IRS. Each bank writes off that bad debt as a business expense. That means that they gave you the difference. In the short sale example, the bank will send the IRS an affidavit stating that they gave you $20,000.00 for a business related expense. You are in essence a 1099 independent contractor employee of the bank for $20,000.00 for the year that they forgiveness occurred. For some, this is meaningless because the difference may not affect their taxes because they don’t make enough, but for many, they will have to pay the income tax on that $20,000.00. They will have to pay the income tax, the social security tax, and the Medicare/Medicaid tax. The Social Security taxes for 1099 income are over 15%. On that $20,000.00, you now owe the IRS over $3,000.00. Depending on what tax bracket you are in, you may owe another $2,000 - $5,000. This creditor is no slouch either, they will file suit, they will garnish your wages, and they will collect their money. If you have a tax refund coming back to you, they will take it.
I am sorry to burden you with more bad news, but you should be prepared if you are in this situation and don’t count on next year’s refund.
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