Taxes Are for Chumps! Underwater Investment Properties Don't Have to Get Soaked!

Last week there were grand articles decrying the fact that not only did GE, maybe one of the largest businesses in the world, not pay any US tax, it got a refund.  So, GE, according to the articles soaked the US government and tax payers alike. I studied U.S. International taxation at the University of Florida to learn how to do and assist companies like GE in accomplishing exactly that outcome.  No U.S. tax.  Is it right?, the rules make it okay.  Is it ethical?  Now that is a debate for philosophers and charlatans.  Suffice it to say, that the Tax Code written by your duly elected congressmen is rife with loop holes that would allow a behemoth like GE to walk through and even some that a small real estate investor can squeeze through too, if he, or she, knows where to look.  Its tight fit, but it acts like a squeegee so you don't get soaked.

I do some digging on AVVO.com an attorney locating website that allows attorneys to answer questions and bump up their rankings.  There was a question presented by a woman, who prior to marrying her husband, had purchased a home to use as a rental income property.  She had the home up for short sale, which implies that it was underwater or upside down, and thus it was also possible it was in danger of foreclosure.  Right up my alley, right?  Her question was, "Is there something other than "insolvency" that I can claim so I don't have to pay "COD" income on the forgiven debt?"

First, let's define a few things.  COD or cancellation of debt, or discharge of indebtedness, income arises under Internal Revenue Code Section 61(a)(12) and is basically the theory that when you take out a loan, you have cash (even though you probably never saw the cash) and that when the loan is forgiven without paying for it, the cash you supposedly had is now income.  Next, insolvency is not bankruptcy insolvency, because the IRS doesn't allow for exemptions like a homestead.  Insolvency is basically you total up all your assets and subtract all your liablities, and if you come out with a negative number, you are insolvent.

The issue the woman was struggling with is that her other assets probably are fairing better than her rental property but she doesn't want to liquidate performing assets to pay the government for what she likely has as a loss on her rental property. Essentially, she isn't insolvent, does she still have to pay the tax.

The first poster to this woman's question went on and on about mortgage forgiveness act of 2007 and was really far off, because he never once looked at IRC section 108(a)(1)(D) which allows for the exclusion of qualified real property business indebtedness income, a fancy way of saying a mortgage on a rental property that is forgiven.

That section, for real estate investor who haven't put their property inside a C-Corporation, and anyone that puts real property in a corporation should shoot their adviser (can I say that in light of Arizona?), is like gold.  Its not perfect, because there are some things to be aware of, but essentially, the investor can exclude from gross income, the amount of COD income that is attributed to the house being underwater.  The investor must subtract that amount from the basis of depreciable property, so the investor will defer the tax, but as Professor Lokken used to say, and probably still says even though he is in Miami, deferment, if done long enough is like a credit. 

So, the doom sayers and charlatans that say your rental property is going to leave you with enormous debts to the IRS probably haven't read through the entire section on excluding COD income.  Remember, to read to the end of the page, otherwise you might get soaked.  Insolvency and Bankruptcy are not the only ways of avoiding this kind of taxable income and even a well healed investor with a bad property can side step paying taxes on COD income if they find the right adviser to keep them dry.


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Napoleon Rises Again - Short Sales and the Foreclosure Waterloo

Okay, I am not a history buff and to be honest, I'm not sure we have a good historical analog to the economic issues that we are facing today.  The amount of leveraging we have seen in the last 10 years is unprecedented and the decrease in real property values, though not undocumented, even under speculation (see housing markets in the 1870s)causing everything to come together in a unique 21st century conundrum. That said, we do have a Waterloo of sorts for foreclosures due to rising costs, and the most famous "short" in history, has to be Mr. Napoleon.

So why would Napoleon rise again in this world of nonjudicial foreclosure?  Well, according to a recent post on higher loss severity rates, investors in Mortgage Backed Securities are seeing incredible declines in their investments.  The measure being used is "loss severity."

If you are unfamiliar with loss severity, don't worry, I had to look it up too.  In a rather dry technical explanation from Moody's, the following definition was given: The loss severity rate (LSR), or loss given default (LGD), is the amount of losses, including both missed interest and principal write-downs, incurred by a defaulted security, as a share of its principal balance. The recovery rate is one minus the loss severity rate.

If you still feel lost, again don't worry, that previous sentence wasn't written for Joe Six-pack, or even for someone that is well versed in investing.  It is specialized to the mortgage backed securities which have spawned thier own language, issues, and neophytes.  The simple explanation is that loss severity is the measure of how much of the investment will never be paid back.  The recovery rate is how much will actually be paid back.

A quick illustration:  You invested $100,000 into a mortgage backed security(MBS) and it has a loss severity of 45%, you will lose $45,000.  Your recovery rate will be $65,000.

Well, the story is that foreclosures are causing these MBS investments to loose more money.  Foreclosure has been estimated to cost upwards of $75,000 though I haven't seen how that number is calculated.  It would seem odd to me that such number includes only direct costs such as attorney's fees, court costs, and the such.  It also likely includes some diminution in value of the loan or collateral in which that number may be low.  Many people that have mortgages now, don't have that mortgage with the company that originated it.  Rather, it is owned by a trust, and that trust has a duty to its investors to make the trust assets perform or at least stop losing value.

In order to accomplish this task of stopping the tide lost value, the trustees are looking past the simple aspect of holding essentially REO property through foreclosure.  In Washington, the number of houses actually sold at Trustee's sale is between 7.5 and 12%.  There is a push to get homeowners to short sale the properties rather than go into foreclosure.

Short sale has benefits to both the homeowner and the holder of the note.  The homeowner gets to be done with the process.  Okay, that is not much of a benefit and to be honest with you,  beyond the benefits certainty and a possibility of avoiding a foreclosure on your credit score, there is little value to a homeowner  in a short sale.  However, the benefits to the note holder are numerous:  Instant cash flow, no cost in holding or marketing the property, no real estate excise taxes, limited losses during falling housing prices and freed up cash for alternative investments. 

The home owner that goes through a short sale has essentially handled the administrative aspects of selling the property for the bank for no compensation.  On top of it, during a falling housing market, the homeowner obtains a better price for the note holder because it did not have to wait until after the foreclosure sale to market the property.  And, I would say the kicker to all of this, is that a short sale limits the possibility of litigation, either from the note holder in a judicial foreclosure, or a restraint of sale action on the part of the homeowner, further limiting the note holder's exposure to mishandled origination and chain of title issues.

So, when the MBS trust that holds the note to your property comes to you and suggests that maybe it would approve a short sale for you, don't be like Napoleon and surrender.  Because, the bottom line is that short sale push is a self interested move on the part of the note holders and not a benevolent change in policy.  Remember, we're Americans, we don't give up.  Live Free or Die.