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.


End of Page

Money may derail Foreclosure Mediation in Washington

I don't know about you, but I used ride trains everywhere.  Of course, not in the US because our mass transit sucks, but in Japan.  Trains are cool, they are powerful, can transport enormous amounts of people and goods, and if you have a Japanese conductor, they are efficient.  The only problem is that they ride on a rail, permanently attached to the ground and if the train ever leaves that rail, well, buckle-up buttercup, cause you will be needing a personal injury attorney.

Yesterday, I attended the House and Senate hearings on the new legislation which is termed Foreclosure Mediation.  The previous posts went into detail on the legal ramifications of the bills (HB 1362 and SB 5275) and I continue to support them.  However, yesterday's Senate Hearing which was Chaired by Senator Steve Hobbs chimed an unfortunate reality, money.

Senator Hobbs pointed out that the fiscal note (link here) that this bill would cost WA taxpayers $3.3 million to implement.  Well, that said, there are some enormous issues with that number, and there is alternative financing that should make the impact to the general budget a net of zero. First of all, the fiscal note assumes that WA will see 40,000 foreclosures next year.  The number is likely accurate, or accurate enough for an estimate as the baseline that the industry experts were throwing out yesterday was somewhere in the vicinity of 30,000 and a recent Realty Track estimate had it at 50,000.  Both numbers are skewed by faulty data because they look at different measures such as the number of notices of default that are filed.  Well, in my practice I have forced one bank to file three notices of default on my one client because the bank is an abject screw up.

The second issue with the foreclosure number is that it includes all foreclosures.  Foreclosure impacts every type of property, whether it is bare land, commercial, industrial, investment, or residential owner-occupied.  The bill only targets the properties that are owner occupied.  So there will only be a percentage of the foreclosures that even qualify for the the program. Since only a percentage qualifies, the expenditures should be quite a bit lower because the government will not be looking at the entire cost for 40,000 foreclosures.

The last issue is that there is a funding mechanism of a $30 surcharge being attached to each notice of default filed with the state.  This fee alone should pay for the project, but that is not all.  Each mediation will cost $400, to be split by the parties.  To enhance the overall effectiveness, a lobby from coalition of 20 mediation clinics in the state said that they were already equipped to handle the mediation and have alternate funding sources already accounted for in the State budgets.  Thus no additional cost.

There was some testimony that County Auditors believe that this $30 fee is not a recording fee, but in actuality a tax which is not properly apportioned, can anyone say Health Care Reform?  This is a valid point which will likely be litigated at some point, but I believe the fee is limited in scope and in actuality is a fee.  I am sure that some Big Law lackey will take up the put-upon bank's sob story and dog and pony show it in front of the court but I believe it is a losing argument.

So the action item from this post, is let Senator Hobbs know that the budget office got it wrong, that the bill is right and good, and don't let tactical delay from the big banks derail good legislation.

Why are you distressed and why will you be taxed?

This blog is being offered partially as a public service, hopefully some of my readers will find the information useful to them as they buckle down for what is to come, and partially as a way for me to express my ideas on the mounting troubles caused by failed policy, greed, and blind decision making by the general public.

My primary audience will  be those that are upside down in their houses, those that owe more than the house is worth, those that want to save the house from foreclosure, those that want to give the house back, and those that are in the process of giving the house back.  Though that description seems to be directed at a bunch of different people, it is not.  Its directed at homeowners who have purchased or refinanced in the last 10 years.  Let's fact it, most of you are underwater. 

There are legal tools that can help people out of this crisis.  There are also practical tools as well.  I hope that this blog will provide a good mix of practicality and if you are really bored, you can read some of my legal rants.

Why are you distressed?  Well, the technical definition of a distressed property is that property is in danger of foreclosure.  Well, this is a narrow definition that Washington State and some other jurisdictions are using to set up enforcement actions against certain vultures.  I use vultures in the sense that there are companies and individuals that are waiting for the first Notice of Default to be recorded in your county and then they swoop down to get your money before you die a financial death.  I believe that distressed property is really any property that has more debt against it than it is worth.

The reason why I think that definition is important is that there are a lot of good people that are trying to pay what they agreed to pay back in say 2006 when the housing market here in Western Washington was strong.  Whether it is from a moral conviction or just not knowing that there are other ways, the person still pays the monthly obligation.  Well, the property, even if you can afford it now, is still distressed because the proverbial straw that broke the camel's back is only an uninsured sickness away.  So the simple fact that you owe more on your house than its worth means that it is stressing you out and thus you are distressed.

So, now we have a baseline for why you are distressed, why will you be taxed?  This is one that many of us don't even consider because lets face it, you have bigger problems to worry about...now.  The person that is living in an underwater house is likely facing reduced income, increased stress, unhappy spouse, nervous children, cranky bosses, and unhappy customers.  It is easy to say, "I have enough on my plate."  The problem is that when the time comes that we part ways with our home, whether it is by the overt act of a person in control of their life or by the fact that the head in the sand, ostrich approach failed, you the homeowner will have some potentially adverse tax consequences.

I know it seems impossible, the home that you paid so much for, is now worth a lot less, so you feel like you had a loss.  The problem is that our tax code does not recognized losses on personal consumption property.  If the property was not purchased to enable you to make more money like an investment property or a commercial property, then the loss you suffer isn't recognized from a tax perspective.  There is no, "I'm sorry you lost your house" box on the 1040 you will file next year.

To add insult to injury, the money you got from the bank, that you really didn't get because it went to an escrow agent and then to the seller is considered income to you after the bank subtracts however much the bank got from the foreclosure, short sale, or deed in lieu.  Oh, did your real estate agent fail to mention that to you?  Sorry, I thought you were working with an ethical agent.  They probably didn't tell you that the short sale they are pushing also is going to cost you an excise tax due on sale of 1.28%.  I know, details, details.

What I am driving at is that distressed properties have hidden "gotcha" traps all through them.  Whether it is information that the banks are not sharing with you about the foreclosure process, or the hidden taxes that will show up afterward, doesn't really matter.  That process of being distressed leads to being taxed, mentally, physically, emotionally, spiritually, and when you get the 1099-C, financially.