Hundreds of American homeowners unknowingly may be setting themselves up for federal tax audits, costly penalties and negative credit reports by participating in commercial programs that promise to get them out of hot water with their mortgage lenders.
One firm alone claims to have helped 2,100 financially distressed homeowners in 40 states during the past year and a half at a minimum $1,000 fee per property for its services. The same firm has been sued by the California state attorney general for alleged marketing misrepresentations. Moreover, firms offering programs to assist distressed buyers triggered an unusual warning to taxpayers from the Internal Revenue Service. The IRS said homeowners who participate in "sham" transfers of title to their property to avoid federal taxes could end up owing a bundle to Uncle Sam instead: back taxes, plus interest and "appropriate penalties."
Here's what the "distressed homeowner" programs offer, and why their rapid spread is upsetting federal and state authorities. The programs are most commonly marketed in areas where real estate values have declined or been flat in recent years - especially on the East and West Coasts. The main targets are homeowners who find themselves in negative equity positions, owing more on their mortgage than the property could bring at sale. For such owners who no longer can, or choose not to, make monthly mortgage payments, the programs offer what appears to be a clever way out. After the homeowners pay a cash fee ranging anywhere from $1,000 to 1 percent of the original mortgage amount, the promoters of the program step in and take title to the house.
The promoters then list the house for sale, notify the lender to expect no further payments on the mortgage, and inform major credit reporting agencies that they - not the borrowers - will now be responsible for any delinquency or foreclosure action taken by the lender. If the property sells before the lender forecloses, the promoters send the net proceeds - usually thousands less than the mortgage debt owed - to the lender. This is known in the trade as a "short sale." If the property goes to foreclosure, the lender also typically recovers far less than the homeowner's outstanding balance.
Relieved debt taxed as income
Now for the rub: Under federal tax law, whenever a taxpayer is relieved of debt, he or she is deemed to have received income. For example, if you owe $100,000 on your house, but your lender takes $80,000 through a short sale, you were relieved of $20,000 in debt. For tax purposes, that's the same as someone handing you $20,000 in cash.
The IRS requires creditors to report the identities of persons who receive debt relief in excess of $600 by sending Form 1099s to the taxpayers and to the IRS. The IRS then routinely runs computer matches of the 1099s sent in by creditors against the tax filings of the individuals identified by the lenders.
Major promoters of distressed homeowner programs, such as San Diego-based Boston Harbor Corp. and Riverside, Calif.-based New England Financial Corp., claim that when they assume legal title to a house and the lender receives less than the full amount owed on the mortgage, the debt relief should be reported against themselves, not the borrowers named on the mortgage documents.
"When New England Financial takes over the property, debt relief liability, whether by short sale or foreclosure, falls on New England Financial Corp., not you," says the firm's promotional brochure. Eric F. Fagan, CEO of Boston Harbor Corp., argues that when his firm takes title to a home, and receives money rather than paying anything itself, it amounts to a bona fide "sale" for income tax purposes. Therefore, he says, no debt relief should be charged to the individuals the firm assists, but rather to his firm, which can then write it off against corporate expenses. Nor should negative credit information be filed against the homeowners.
Consumer allegedly mislead
California's attorney general disagrees strenuously. His office has sued Boston Harbor for $500,000 in civil penalties and is seeking restitution of clients' funds for allegedly misleading consumers about avoiding tax liabilities and bad credit reports. Trial date has been set for February 1996, according to Deputy Attorney General Dennis W. Dawson. At least six other companies offer similar programs, he said.
An IRS spokeswoman in Los Angeles, Laura Keleman, said the agency's view of the third-party debt-relief concept is best summed up by the following warning to homeowners issued this year: "The plan doesn't work. The transfer of property to (a third-party) company is not a bona fide sale. Thus, it won't affect forgiveness of debt . . . or income recognition." Keleman said lenders are contacting the IRS with tips about homeowners and firms involved in "sham" transfers.
The upshot for homeowners? Unless you enjoy IRS audits, proceed with extreme caution and solid legal advice.
(Copyright, 1995, Washington Post Writers Group.)