by Blue Water Credit……www.bluewatercredit.com……7-13-11
I am often asked what the impact of a short sale or foreclosure is on a credit score. Unfortunately, there is no straight-forward answer. This is such a difficult question to answer simply because it depends on a variety of factors. In general, a short sale or foreclosure will affect your credit score 85-160 points. Many mistakenly believe, or are misinformed, that a derogatory credit event such as a foreclosure is somehow worse than a short sale. In the world of credit scores, however, both of these events look the same way; the customer did not pay as agreed.
What Is A Credit Score?
A credit score is the statistical prediction of one’s likelihood to pay late over the next two years. The higher the score, the less likely one is to have a late payment. The bank then uses this number to assess the amount of risk involved with lending someone money. Banks are a lot like a casino in a sense, they like to place bets where they feel they will win.
Be aware that there are multiple credit scoring models. Some of the credit scores in these models go up to 990. While there are multiple formulas for calculating credit scores, the formulas introduced by the Fair Isaac Corporation (FICO) are the most widely used. This score ranges from 300-850. Fair Isaac recently released a report stating that credit scores are affected nearly the same whether you go through a foreclosure or short sale. The report stated that the average points lost on a FICO score are as follows:
30 Days Late = 40 to 110 Points
90 Days Late = 70 to 135 Points
Foreclosure = 85-160 Points
Short Sale = 85-160 Points
Deed-in-lieu = 85-160 Points
Bankruptcy =130 to 230 Points
How Are Short Sales Reported To The Credit Bureaus?
FICO does not differentiate between a foreclosure and a short sale. Further complicating matters, lenders don’t have a uniform standard as to how they report a short sale to the credit bureaus. Some lenders report short sales as “settled as agreed” while others may report it as “account legally paid in full for less than the full balance.” In some cases, if the account is more than 120 days past due, the short sale will automatically show up as a “foreclosure” on the credit report. Both a short sale and a foreclosure will report on your credit for seven years from the date of first delinquency.
How to Maximize Your Credit Score during a Short Sale or Foreclosure
Since the number of delinquent accounts is factored into the score, try not to let any other accounts become late or delinquent (if possible). The second largest factor of your credit score is your debt ratio (the limit of your credit cards compared to the balances you carry) try not to let your balances exceed 30% of the limit. Only apply for credit when absolutely necessary. Do not close your credit cards. If you are able to do all of these things you will be back into the 700’s before you know it.
Credit scores play a large factor in our lives, but ultimately we have many other priorities that are more important. Credit, like many other things, will be healed over time.
Friday, August 5, 2011
Wednesday, July 6, 2011
Short Sale Q&A
1. Do I have a tax liability if I short sale my primary residence?
Many people are under the impression that due to the Mortgage Debt Relief Act they will have no tax liability when short selling a residential property. This is not always the case. The Mortgage Debt Relief Act applies to individuals short selling their primary residence and only applies to qualified principal residence indebtedness. This Act also expires on 12/31/12. Individuals who short sell a home will receive a 1099-C from the bank. This 1099-C is reported to the Federal and State taxing agencies and must be reported on the Federal and State tax returns. If the property in question is an individual’s primary residence, and the entire amount owing is qualified principal residence indebtedness then there will be no tax for Federal and State purposes.
2. What is qualified principal residence indebtedness?
Qualified principal residence indebtedness [according to IRC Sec 108(h)] is the money, up to $2,000,000 ($1,000,000 if MFS) of debt incurred to acquire, construct or substantially improve the taxpayer’s principal residence. A refinancing of such debt also qualifies. The debt must be secured by the residence, and the taxpayer must have lived in the residence for 2 of the last 5 years.
3. How do I report the short sale of my rental property?
Short selling a rental property can be difficult to compute because there is a lot more to consider. Firstly, you must address whether or not the amount due on the loan is money used to purchase, construct or substantially improve that specific property. If there is only one loan on the property and that loan was used to purchase the property then the equation becomes much simpler. The cost basis on the property is the total purchase price plus improvements to the property less accumulated depreciation. This will give you the adjusted cost basis of the property. If the sales price is less than that amount you will generate an ordinary loss on your tax return.
The other side of the equation is the ordinary income you will report as a result of receiving debt cancellation reported on a 1099-C.
More frequently then not the amount of ordinary loss from the sale of the rental can negate all or a portion of the ordinary income from the cancellation of debt. If you find that you have more cancellation of debt than you do loss from the sale of the property then it is always important to consider the taxpayer’s level of insolvency. Insolvency can be another way of excluding the income. This is something that must be looked at very carefully and can get tricky, however it often benefits the taxpayer to have a professional with experience in this area to take a look at your specific situation and give you an idea of where you stand.
4. How do I know if I am insolvent?
Insolvency applies when a taxpayer’s total debts exceed their total assets. To compute insolvency the taxpayer must complete the insolvency worksheet and include this information with IRS Form 982 with their tax return in the applicable year. The important thing to understand about insolvency as it relates to cancellation of debt from the sale of property is that your insolvency must be calculated immediately preceding the sale. This calculation must be completed before the property sells in order to report correctly even though the transaction is not reported to the IRS until the annual filing of the tax return. Additionally, when claiming the insolvency exemption a taxpayer may have to reduce tax attributes in the following year, meaning a Net Operating Carryover or a Capital Loss Carryover or possibly the basis in other real property owned by the taxpayer at the beginning of the following year. This is again a very complex issue and must be analyzed with a tax professional in order to understand to what extent these effects will be implemented in each individual case.
5. What happens if I am partially solvent?
If you complete the computation and find that you are solvent by $20,000 but your debt forgiveness is $50,000 then you will only include the $30,000 in your taxable income for both Federal and State purposes. If you find that you are insolvent by an amount greater than your canceled debt then you will have no tax liability to either Federal or State.
6. What happens if I do not receive a 1099-C?
There are a couple of instances where a taxpayer may not receive a 1099-C in the mail. Often times the banks are too far behind in their paperwork to be able to follow the taxpayer to the new address and so the 1099-C is delivered to the address where the short sale occurred. This does not make much sense, however it happens frequently. The resolution to this problem is to contact the IRS and request a copy of the taxpayer’s income transcripts. These will show whether or not a 1099 has been issued.
The other instance in which a taxpayer may not receive a 1099-C is if the debt forgiven was recourse debt. With recourse debt the individual responsible for repaying the debt is personally liable for repayment of the debt. The 1099-C is issued when debt is cancelled or forgiven, sometimes the bank does not forgive the debt and intends on suing the responsible person. This is an issue that your Realtor can negotiate with the bank and should be looked at very carefully. If your Realtor can negotiate a reduction in the amount due for recourse debt then the remaining amount will be cancelled debt. This may result in an increased tax liability however the tax liability incurred will always be less than the amount you would otherwise be responsible to repay. In any event the possibility remains that if you do not receive a 1099-C it may be because the bank intends on holding you personally liable for repayment of the loan.7. What happens if I have a large tax liability and I cannot afford to pay the IRS/FTB?
If you incur a large tax liability and you do not have sufficient funds to pay the taxing agency you have the ability to apply for an installment agreement. There is a small fee to each agency for constructing a payment plan and each agency does charge a small percentage for interest. However, if you have an amount due and you choose not to pay the amount due in full nor apply for an installment agreement then the taxing agencies will pursue other means such as levying your bank accounts etc. Installment agreements are easy to complete and the agencies are typically agreeable to working with taxpayer’s trying to settle liabilities.
8. Should I file Bankruptcy?
If you have filed Bankruptcy you need to consult with a tax professional right away. This issue is extremely confusing but the basics are: If you file Bankruptcy in any year and then the house sells in that same year then you are fine. If the Bankruptcy is discharged in one year and the house sells after January 1 of the following year then you may have a big problem. Bankruptcy is similar to Insolvency in that you must reduce tax attributes at the January 1 of the year after the debts were discharged. Remember that the basis in real property is a tax attribute. If the basis is reduced at January 1 of the following year to $0 then you will pay ~ 35% in taxes on the entire amount of the sales price.
Bankruptcy is sometimes the best option, however there is a very sensitive timeline that MUST be followed to ensure maximum benefits. Again, you should never file the Bankruptcy prior to the short sale or foreclosure unless you understand the liability and accept the risk.
9. Does any of this change if I do a Deed in Lieu or a foreclosure?
This very simple answer to this is NO. You will experience all of the same tax implications no matter how you dispose of the property. All of the above options will be treated as a sale of the property on your tax return. The only difference is that in a foreclosure you may be giving up some of the control over price and timeline that may be important to you. You must first identify what you need/want to happen and then decide whether your timeline and price point are open or if you need them to be fixed. A short sale is the only way to allow yourself the chance at getting what you need to reduce tax implications.
10. What about my loss of Itemized Deductions after the sale?
You will lose the deductions you have been taking from owning your home, so you will need to consult with your tax advisor regarding a possible increase to your withholding rate and/or some other creative possibilities, such as increasing your 401k contributions. These changes can offset your taxable income in the same way your itemized deductions did in prior years. Budgeting becomes key here so it is always a good idea to meet your tax advisor for a budgeting meeting prior to renting a new house. This will tell you what you are eligible to do for retirement savings and you can construct your new budget from there.
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