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The www.FedPrimeRate.com Personal Finance Blog and Magazine

Wednesday, May 19, 2010

A Strategic Default on Your Mortgage May Cost You More Than You Think

Strategic Default may result in a huge tax billI was listening to some business news the other day. According to the well respected economist who was being interviewed, folks who have been walking away from their home loans in response to owing more on their home than their home is worth, have been helping to fuel consumer spending. The money that was being used to pay the mortgage has been freed up to be spent on other things. Great news for this fledgling economic recovery, but going the strategic default route should never be taken lightly. Not only will your credit score being ruined for years, you may end up with a massive tax bill from the Internal Revenue Service (IRS).

Here's a clip from a great WSJ personal finance article:

"...Americans considering walking away from an unaffordable mortgage: Beware of taxes.

Though not every homeowner who's underwater on a mortgage need worry, many are finding that a foreclosure or other form of housing loss can lead to a big tax obligation.

Maxine McDaniel walked away from her Loveland, Colo., home in January. Now the 59-year-old nurse faces a potentially huge tax bill.

In Ms. McDaniel's case, the 59-year-old in January abandoned the 4,300-square-foot Loveland, Colo., home she and her late husband built. After her husband's death in July 2008, Ms. McDaniel, who earns about $34,000 a year as a home-health nurse, couldn't maintain the $3,000 monthly payments necessary on her nearly $500,000 interest-only mortgage. So she stopped making them and moved in with an uncle.

Now, she's bracing for the next blow: an Internal Revenue Service form detailing as much as $150,000 in debt canceled by the bank when it took control of the house. The canceled debt is a form of income, says the IRS—meaning she'll owe taxes on it.

'I had no clue this would happen,' says Ms. McDaniel, who, with her husband, had refinanced at least three times, including one cash-out loan. That transaction caused her problems because, while canceled debt originally used to buy or build a house can be exempted from tax filings, debt used for other purposes cannot. 'I just thought I'd get out from under the house and that would be that,' she says.

As the U.S. economy continues struggling with the fallout of the debt-induced housing crisis, millions of homeowners like Ms. McDaniel are discovering that their decision to walk away from a mortgage could result in tax bills running into the thousands or tens of thousands of dollars.

The upshot: anyone weighing whether or not to seek a mortgage modification—or debating whether to abandon a house that is worth less than the mortgage—should consider the tax treatment carefully before making a move. The same holds for any form of consumer debt that a bank ultimately cancels, including credit-card balances or an auto lease.

Federal and state tax laws have long viewed canceled debt as income because consumers who borrow money to buy a house—or who pull money out of their house to buy cars and such—and then don't pay it back 'wind up ahead of where they were,' says an IRS spokesman.

Thus far this year, Michele Knight, a CPA with a high-end clientele in Keystone, Colo., has had five clients owe taxes tied to houses and another five tied to credit cards and auto leases. 'They're calling me in tears and saying, 'What do you mean I owe taxes?'" she says. 'I never would have expected it.'

Dianne Corsbie, a White Plains, N.Y., financial planner, says about 5% of her 200-client practice owes taxes because of a foreclosure, most tied to investment properties. In Napa, Calif., Duane Carey, owner of a Ranch Tax Service, says every fifth person he sees 'comes in angry, holding one of these 1099s.'

Overall, the IRS estimates that individual taxpayers will have filed nearly 3.6 million tax returns for 2009 that include income from canceled debt. That's down a bit from 2008, but up 17% from 2007. The numbers include taxes due on primary homes, vacation and rental property, credit cards, auto leases and other canceled debts. The IRS projects the numbers to rise in coming years.

Part of that rise will likely come as the government expands its mortgage-modification program, including a call in March by the Obama administration for banks to reduce principal as a way to help people remain in their homes. That reduction could lead to tax obligations.

At first the government's mortgage-modification program focused on primary mortgages, which are tied to the purchase or construction of a primary residence, and which are eligible for exemption under a 2007 Congressional act aimed at helping homeowners avoid the tax implications of a foreclosure.

That act—the 2007 Mortgage Forgiveness Debt Relief Act—exempts taxpayers from as much as $2 million in forgiven debt. But the debt had to be acquired before Jan. 1, 2009—and had to have been used solely to buy, build or remodel/repair a primary residence.

The government's new, expanded modification programs include short sales, in which a bank agrees to accept as full payment less than the value of the mortgage balance; deed-in-lieu transactions, when a homeowner gives the house to the bank instead of repaying the mortgage; and second mortgages such as home-equity lines of credit.

In many of those instances, say Treasury officials, homeowners used mortgage money to fund everything from tuition and medical bills to vacations and cars and even the down payment on a second home or investment property. That debt, however, isn't eligible for exemption.

Sometimes the tax bills are so high that people can't afford to pay. In such a situation, the IRS will allow taxpayers to apply for an installment-payment plan.

Some homeowners can avoid the taxes completely if they can prove insolvency, in which the total value of debt exceeds total assets. But even that could leave some owing taxes.

IRS rules stipulate that a taxpayer can escape taxes up to the extent of insolvency, meaning that if one's liabilities are $500,000 and assets are $300,000, the $200,000 difference is the extent of the insolvency. But if the person has $250,000 in debt canceled, then $50,000 is taxable income.

'People think their house was underwater, so they're insolvent and can get out of owing taxes,' says Arthur Auerbach, a member of the Individual Income Tax Technical Resource Panel at the American Institute of Certified Public Accountants. 'But it doesn't work that way...'"

If you visit WSJ online to read the full story, be sure to read the comments. Lots of insight there, as usual. Enjoy!

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Friday, May 14, 2010

New York Times "Debt Trap" Interactive

Just came across a "Debt Trap Interactive" on the New York Times website, and fell in love. It's very well done. It was made back in July of 2008, just before the global banking crisis which put us into this Great Recession. But it's still relevant today. I compared my debt to others in the U.S. and was not happy with my ranking. Lots of Americans are doing a lot better than I am -- and God bless them. Studying the numbers has helped me to realize that I really need to start ignoring the platitudes my friends and relatives have been offering me in recent months, and get my ass in gear.

Time to find a second job, I guess. It's going to be real hard, as the job market is still crappy, and I love what I do. But I need to make a lot more money, and job opportunities are starting to show up more often. There's a new casino opening up about a 10 minute drive from my place. Lots of positions that need filling. I wouldn't mind a security job -- with benefits, of course -- where I could get away with getting lots of reading done on the job. That would be sweet. I'm having a great time learning about economics these days, a subject I avoided in school due to all the math involved, but really love now. Real world economics is very interesting, and every time I learn something economics-related, I feel a lot smarter than before I owned that particular nugget of knowledge. Viva economics!

To explore the NYT Debt Trap Interactive, click here. Enjoy!

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Tuesday, May 11, 2010

The Art of Complaining

The Art of ComplainingMy husband and I volunteer as a host family to a Russian student at our local university. Over spring break, Masha traveled to see her mother and spent a day and a half in Chicago O'Hare International Airport because her flight was late, causing her to miss her connection.

Masha and I had lunch after her trip, and she told me about her ordeal, being awake for 18 hours straight, going from counter to counter, being bumped off flights, not sleeping and not even having the luxury of being able to study.

"You must write a letter," I told her.

"I have no idea how to do that," said Masha.

Her dilemma was not only rooted in a cultural difference, but a generational one. With the technological ease of e-mail and instant messaging, many people today simply do not have the knowledge of how to write a good old-fashioned letter of complaint. But I have found that even in the electronic age, a hard-copy letter, signed with multiple CCs has a power all its own.

As we sat, waiting for our lunch, I helped her craft a draft to United Airlines, which began with "Dear Customer Representative." We told her story in detail, including the poignant line, "My American friends could not believe that I didn't even get airport vouchers for a Cinnabon purchase."

As I advised, Masha sent a hard-copy letter to United, CCing every official entity she could think of, including the Russian Embassy.

Two weeks later, she received a letter of apology and a voucher for $150 on her next flight.
As I enter middle age, I have discovered that there is indeed an art and efficacy to the complaint. And there are rules.

First, you must find the proper person to whom to complain. If you have had a problem with a Walmart clerk, do not complain to that person, but that person's manager. Do not be afraid of asking for a supervisor. When I was trying to negotiate to delete a late charge with Discover, the phone representative said there was nothing I could do. I asked for his manager. As a result, I, as a long-term customer who had never been late on bill before, was not only able to get a refund on the late fee but also have my promotional rate restored.

Second, make sure you have evidence to support your complaint -- a broken product, receipt, or witnesses.

Third, follow the old aphorism that honey is more effective than vinegar. Do not yell or have a hissy fit -- particularly if you are a woman, as you will be seen as hysterical rather than justly injured. Try to stick to the facts as much as possible, but don't be afraid to insert an honest and sane appeal, such as, "I have been shopping here all of my life and have never experienced such poor customer service. As a long-time and loyal customer, I am disappointed in your treatment."

Finally, suggest a reasonable and acceptable appeasement. When my husband and I were literally chastised by a Walmart employee while purchasing an iPhone, I complained to the manager and told him that I would be happy with a deluxe phone case for our problems. We went home with the case.

Last week, I purchased a Roomba from KMart. When I bought it, the clerk asked if I wanted the three-year guarantee, which I declined. When I got home, I discovered that the Roomba had been used. I immediately returned it to KMart for a replacement. While at the service desk, I asked the clerk if KMart would be willing to comp me the guarantee for the inconvenience. She phoned her manager, and it was done. I walked out of the store, as a satisfied and well compensated consumer.

When you feel you have been wronged in business transaction, don't bite your tongue, but respond in a reasoned and respectful way. You will be surprised by the results.

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