Can I Settle My Second Mortgage Without a Tax Liability?

Question:

Dear Steve,

I have lived in my house for 16 years. Due to various circumstances, I have fallen behind on mortgage payments. My primary lender has filed for foreclosure as a result. My home is currently listed for sale. I have a smaller second mortgage with Chase that was a piggyback loan on a refi. I have just received an offer from them to settle the debt for $0.10 on the dollar. I also have a HELOC.

If I pay the offered lump sum settlement from Chase, and they release the lien, do they have any recourse if I sell the house and walk away with some equity? The notice makes it sound like all I have to do is pay the lump sum, and the loan is taken care of once and for all.

Thanks for any guidance you can provide.

Ellie

Answer:

Dear Ellie,

It’s amazing how such a simple question can led to such a complicated answer.

The issue here is how your settled debt will be treated by the lender, in this case Chase. If you do settle the debt then you may receive a 1099-C tax form showing the forgiven debt. There are situations where you might owe income tax on the forgiven debt.

Typically forgiven mortgage debt would be not taxable in 2016 due to the extension of the The Mortgage Forgiveness Debt Relief Act of 2007.

But when you remain in your home following a settlement and the forgiven loan is not the subject of a foreclosure it creates a question that I think only a tax expert can answer. You see, the Mortgage Forgiveness Debt Relief Act prevents a tax liability through 2016 if the debt was “incurred to purchase, build, or make significant renovations to your principal residence.” I’m not sure if that applies to your second mortgage.

Additionally, a qualifying debt under this tax policy can include mortgages that were reduced through modification or restructuring or mortgage debt that has been canceled altogether through foreclosure. But that does not sound like it specifically deals with your second mortgage because the second mortgage is not initiating the foreclosure and would be potentially settled prior to foreclosure.

Even the instructions for the IRS Form 982 you would have to complete are not clear regarding your unique situation.

If you settle the second mortgage with Chase and you have a letter stating that the settlement fulfills the loan then Chase would not have a recourse. That’s the least of the issues here.

However, the bigger issue here is if you settle the loan with Chase, will the first mortgage lender give you enough time to sell or are you throwing good money after bad.

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If the first lender does not give you enough time to sell then the foreclosure can take place anyway. While the HELOC would be cleared from the lien it would not clear your obligation to repay it.

Rather than settling, which at this point seems like an incomplete solution, I would suggest you meet with a bankruptcy attorney who is licensed in your state.

If your home is foreclosed on and you subsequently filed bankruptcy then all the debt discharged by bankruptcy would be eliminated tax free.

Here is the worst case scenario as I see it – you settle the second mortgage, the first mortgage lender forecloses anyway and you are left with a balance due. The foreclosure auction does not have to raise enough to cover your first mortgage. Any balance due would be your responsibility and potentially you could be sued for that amount. The HELOC remains a debt owed by you.

You might be able to get out from under your forgiven debt tax liability up to the point you become solvent. The IRS has forms for that. But I would suggest if you are going to count on any IRS process to forgive any tax liability from a first mortgage, settled second mortgage, and HELOC, you first discuss this with a qualified tax preparer in your area. This is not the type of surprise you want later. This way you can be better prepared to evaluate if the bankruptcy route with full tax liability discharge protection would make more sense for you.

You might also want to read Why It Makes Sense to Consider Debt Settlement for Second Mortgages and HELOCs.