First, there is a difference between walking away from the property when you can afford to make the payments and when you cannot. It is called a strategic default, when you have the ability to make the payments but decide it serves you better to stop making payments and let the bank foreclose on your home.
If you are in a hardship and are not able to maintain your payment relationship, you face a different set of choices. If you are in a hardship, there may be options including loan modification and principle reduction. If you can afford to make the payments, then these options will not be readily available.
For those considering a strategic default, here are some factors to consider.
Financial Benefits and Costs of Foreclosure
Is this a wise business decision? Will the cash flow benefits be large enough to justify walking away from the loan? In your case, the financial benefits would likely be quite large. You would be able to invest all the monies that you are putting into your home into alternative investments and into retirement accounts. You will not have any rental costs to replace the current mortgage, because it is a second home. In general cases, things that need to be considered include how much rent will be paid for new housing, instead of the mortgage, insurance, property taxes and upkeep? How much appreciation will there be over the period of time you would consider holding on to the property before selling it? For homes that are eligible for a home-interest tax deduction, include the loss of that benefit in your cost/benefit analysis.
Tax Implications of Foreclosure
A serious financial cost to consider is the tax implications. In your case, because your home is an investment property, the lender can send you a 1099, forcing you to declare as income the entire amount of debt that is forgiven. Supposing the lender could sell the home for the approximate $97,000 that you estimated, that would leave you with a 1099-C of $87,000. Not only does an extra $87,000 in income have a large tax associated with it, it could raise your tax bracket, making it so you will owe more than you would have on the rest of the income you earned.
There is a Federal law, The Mortgage Debt Relief Act of 2007, that allows income from a short sale to be excused from being declared as income, but it applies only to certain cases. It almost always does not apply to second homes and even on first homes it only applies in limited cases. For instance, regarding loans used to purchase the home or to upgrade the home, the borrower does not need to declare as income the amount of the debt forgiven. If, however, a person refinanced a home and took cash out to consolidate other debt or used for personal needs, like a vacation or to purchase a car, there is no release from the tax obligation. You can read about the IRS tax implications for mortgage debt forgiveness.
State taxes are a separate matter. Each State has its own rules. Regarding both the IRS and State tax implications, you should check with a CPA or Tax Lawyer. Also, laws can and do change. The protections in the Mortgage Debt Relief Act are set to expire, covering foreclosures that take place from 2007 through 2012.
Effects on Credit of Foreclosure
Foreclosure and the missed payments that precede it will greatly decrease your score. How important is your credit score to you? In your case, you indicated that maintaining creditworthiness is a “necessity,” to make sure you are positioned, as best as possible, to attend to your son’s medical needs. For many people who are underwater (home value less than mortgage balance) this is not necessarily important as either they already have poor credit score, a decline in credit score is inevitably on the way, so that the benefits of the dollar savings outweigh the impact on the credit.
In general, it is easier to rebuild credit than it is to pay off a large debt. Still, it is important to factor into any decision the effects on your credit, as credit is used not only to determine your ability to qualify for loans, but can be used by employers in determining whether or not to hire someone and landlords when weighing whether or not to rent. Some jobs, such as ones that require a security clearance can be jeopardized, even when already employed, be the appearance of serious derogatory information on a credit report.
Recourse or Non-Recourse Loan
Is the loan a non-recourse or a recourse loan? Recourse loans are loans that allow the lender to come after you in case you default. Non-recourse loans limit the lenders ability to collect on the defaulted debt by going after the collateral that was used to secure the loan. Check with an attorney regarding laws relevant to your area of residence (where you have your assets) and the area of the asset itself, if they are located in different states.
If the property is situated in Arizona, then you may be in luck because Arizona law does not allow the collection of deficiency balances under some circumstances. Arizona’s anti-deficiency laws are tricky, however, and because the property is not your principal residence the consumer protections may not apply. See the Bills.com resource Arizona Collection Laws for a longer discussion of Arizona’s anti-deficiency rules and links to the relevant statutes.
Morality of Foreclosure
The moral implications are far different for someone who can no longer make the payments and someone who chooses to stop paying when he can afford to do so. Is it a morally correct decision to stop paying, when able to pay, only because the house is worth less than is owed for it? After all, if the house had gone up in value, it is the borrower who wants the profit, so is it fair that the borrower does not suffer the loss if the property drops in value. There are various viewpoints and complicating factors on this matter and each person must gauge this on his own moral turf.
Choosing to walk away from a mortgage is a very big step. As I mentioned, the risks are different in different jurisdictions, so it is advisable to seek legal counsel or, at the very least, seek a free consultation through resources. One free source available is that you can talk to a housing counselor at the U.S. Dept of Housing and Urban Development.
In your particular case, you state clearly you currently can afford the payments and do not want to adversely affect your credit rating. Given the large decrease in property value and your assumption that appreciation will be marginal it would seem economically wrong to accelerate payments. I would advise continuing to make the payments based on your original 30-year loan. Extra monies you earmarked for paying down the principal should be used to bolster your retirement accounts and properly invested and safeguarded with an estate planner. Speaking with an attorney who specializes in Estate Planning also will allow you to establish the best way to provide for your son now, in the near future, and after your death. You may be advised to set up a Family Trust that protects your assets as best as possible from future taxation and sets up clear guidelines for your son’s future medical care.
In addition, renting the property, which you are already considering, is worth looking into. If you do it in a prudent manner with the correct safeguards, it will curtail some of your losses. This strategy would allow you to review in a number of years whether your investments produced better returns than the mortgage, the appreciation of the house reduced your losses, or whether your financial situation (presumably making less money once you retire) would make it more feasible to either qualify for a loan modification or suffer a lowering in your credit report from a more radical approach like foreclosure.
See also the Bills.com resource Strategic Mortgage Default to learn former Treasury Secretary Henry M. Paulson Jr.’s, and Brent T. White, University of Arizona law professor’s opinions on strategic default.
I hope this information helps you Find. Learn & Save.