So many people have walked away from homes that are hopelessly underwater. With little prospect of recouping their losses, or faced with a difficult personal financial situation, they have made a decision to let the bank foreclose. Prior to 2007 this would have resulted in an income tax liability on the amount of any forgiven debt. Currently the law allows people to walk away from their primary residence without fear of IRS consequences through the end of 2012. Rental properties are another matter. Investors walking away from investment properties are still liable for income tax on the amount of any debt discharged by the lenders.
The real estate bubble lured many neophyte investors into the water with easy money and unsustainable rates of appreciation. When the music stopped many of them were holding multiple properties while drowning in debt. Even experienced investors were feeling the pain. Watching homeowners walk away from their primary residence, seemingly without consequences, led many investors to believe they could do the same. They should have read the fine print.
Debt Relief Act
The Mortgage Debt Relief Act of 2007 allowed homeowners to avoid paying taxes on forgiven debt but investors were specifically excluded from this law. Right or wrong, investors are presumed to be more sophisticated and aware of the risks. At real estate club meetings I have encountered investors talking about “strategic default” and letting the banks have their headaches. When asked about the taxes they would respond that they had lost money so there would be no tax due. When asked about the tax consequences of forgiven debt I would be told that the law forgives it (it doesn’t) or, more often, I would receive a blank stare in response. It was clear that they were so concerned with immediate relief of their debt pain that they hadn’t considered the tax ramifications nor had the consulted a legal or tax professional.
Some investors view bankruptcy as an option. Debts accrued personally and in their business can often be discharged this way. IRS debt? Not so easy. While not impossible, eliminating taxes owed to the IRS is an onerous process. Trying to do so without the aid of a professional is certainly not advised.
If an investor needs to walk away in a strategic default, or engage in a short-sale of an investment property, proper planning is essential. Investors need a strategy when they begin investing but they also need one for any significant changes that occur in their business. Defaulting on a debt is certainly a significant event. If you are considering strategic default as an option be sure you do so with your eyes open. It is no surprise that investors, especially formerly successful ones, may find the thought of walking away from debt obligations to be humiliating and embarrassing. However, it’s not a time to bury your head in the sand or avoid facing the issue. Swallow your pride and seek the advice of professionals before you act. No one plans to fail, but they often fail to plan ? the two are often related.
Remember that failure is an event, not a person. – Zig Ziglar