By Scott Van Voorhis
New York’s worst-in-the-nation foreclosure mess could get even more tangled in 2013, with the looming expiration of a tax break key to helping distressed homeowners unload their properties. Federal legislation has shielded homeowners who avoid foreclosure through a short sale from having to shell out potentially thousands in additional taxes. But that tax break is set to expire on Jan. 1, with potentially disastrous results on foreclosure prevention efforts in New York and across the country, industry observers say.
If not reenacted, the prospect of a major tax hit could put the brakes on short sales, further adding to the considerable foreclosure backlog in the Empire State. New York holds the nation’s highest average of 1,072 days for a lender to complete a foreclosure, from initial filing to auction. That’s well above even New Jersey, number two at 931 days.
“The national average is 382 days,” noted Daren Blomquist, RealtyTrac vice president. “It’s almost unbelievable,” he said, referring to New York’s dramatically slower rate.
Passed by Congress in 2007, the Mortgage Debt Relief Act has shielded millions of homeowners from a rather nasty tax hit that typically accompanies a short sale, a principal reduction on a loan, or even a foreclosure.
The key issue is the amount of debt a lender forgives on the mortgage, which in a short sale is the difference between the total on what the home sells for and what is still owed on the mortgage. If, for example, a homeowner sells for $300,000 but still owes $350,000 on the mortgage, the IRS, barring an extension of the 2007 federal legislation, would count that as $50,000 in extra, taxable income.
Homeowners who get the bank to write down part of their loan would have to pay taxes on the difference, notes Salvatore Prividera Jr., director of communications for the New York State Association of Realtors.
Of course, while it may be considered income by the IRS, homeowners facing serious mortgage problems are not exactly seeing the money, Prividera said. In fact, the tax hit will likely affect the most vulnerable homeowners at what may be one of the lowest point of their financial lives.
Many underwater homeowners may be scrambling to make payments after a loss of a job or a cut in income. For homeowners on the fence about doing a short sale, the prospect of a big federal income tax hit could take away the most promising escape route out of trouble.
“With the tax piece expiring at the end of the year, it is a quality of life issue for the individuals involved,” Prividera said. “They are not seeing the money they are having to report as income. It makes a difficult situation even more untenable for those trying to deal with the situation.”
In fact, real estate agents in New York state are already recognizing the reality. Prividera said he is hearing anecdotal reports about agents pushing homeowners to move ahead with short sales before the year ends.
From bad to worse?
The big question is what the uptick in homes falling into arrears and becoming unsaleable will do to New York’s already broken foreclosure processing system. New York’s total foreclosure backlog totals just under 40,000. That’s enough to put it the top 10, though behind California, with its 175,000 foreclosures, or Illinois, with its 85,000 distressed properties, RealtyTrac reports.
If short sales are suddenly hit with crushing federal taxes in early 2013, it could jam New York’s already clogged foreclosure pipeline with thousands of new homes, based on current sales numbers. As it stands now, short sales make up 14 percent of all sales nationwide and a smaller, but still significant percentage of the New York market, Bloomquist said.
More than 27,000 homes were sold in the Empire State during the third quarter alone, according to the New York State Association of Realtors.
“Short sales have been an important escape valve for the banks,” Bloomquist said. “But if that escape valve is taken away, or homeowners are just not as willing, they may have to resort back to foreclosures again.”
Given the state’s extraordinarily cumbersome system for dealing with foreclosures, just about any increase in volume could have a detrimental impact. For starters, New York requires that foreclosure cases go before judges, generally a more cumbersome process. But long before the lender can bring its foreclosure petition to the judge, it has to take part in mandated mediation sessions with the homeowner aimed at trying to hammer out a deal.
New York is one of a handful of states that mandates such negotiations between banks and homeowners before court officials will allow lenders to move ahead with foreclosures, Bloomquist said.
New York’s courts and Legislature have also made it tougher for lenders to move ahead with foreclosures. Suffolk County Supreme Court Justice Jeffrey A. Spinner made headlines in 2010 when he cancelled the mortgage of a Long Island couple, wiping out, with a stroke of a pen, $292,500 in debt. Spinner based his decision on what he declared to be the “shocking and repulsive” acts by the mortgage servicer in dealing with the couple’s efforts to get their loan modified.
State lawmakers have also added a legal twist for New York lenders seeking to foreclose on a homeowner no longer making payments. The Legislature last year passed a bill enabling homeowners who successfully contest foreclosures to recoup legal fees from their lenders.
“The Legislature, in its infinite wisdom, has made the foreclosure process almost impossible,” said Joshua Stein, chairman of the education committee of the Mortgage Bankers Association of New York. “There seems to be an underlying policy goal of preventing lenders from foreclosing. Every session they come up with a new burden.”
“It’s out of control,” he said.
Clock ticking down
When this article was written earlier in the fall, a couple of key local lawmakers were lobbying hard for an extension of federal Mortgage Debt Relief Act. Two New York congressmen, Tom Reed, a Republican, and Charles Rangel, a Democrat, both pushed separate bills to extend the tax relief for short sales.
The National Association of Realtors pushed hard for an extension as well. But in late October, attempts to extend the debt relief act were stalled in committee in both the House and Senate, with no sign of any movement.
While the presidential election was a major distraction, Congress will soon have other bigger fish to fry as well.
All eyes right now on are the looming fiscal cliff. That’s the series of draconian tax increases and spending cuts are set to go into effect next year unless Congress can craft a sweeping, deficit reduction bill.
Given the high stakes involved, it’s anyone’s guess how quickly Congress will get around to extending the tax break on short sales, set to expire Dec. 31.
“Things could get worse before they get better,” said Ed Mermelstein, a real estate attorney and co-founder of international real estate law firm Rheem Bell & Mermelstein in New York. Speaking in late October, he said, “There are lots of question marks and you have lots of very nervous people sitting on sidelines, wondering what is going to happen.”