Consequences of Foreclosure

Once a home is lost to foreclosure, the homeowner’s credit score will drop by as much as 250-280 points. Only three years or more of on-time payments will restore the credit score. In case the foreclosure is an isolated event and the credit record is otherwise sound, consumers may be able to rehabilitate their records in 24 months. But this is a rarity as foreclosure normally comes hand in hand with escalating rates that only push the individual deeper and deeper into debt.

Many years of expensive and limited credit are the long term consequences of foreclosure, making financial recovery very difficult, if not near to impossible. The components of a FICO score consist of payment history: 35 percent / amounts owed: 30 percent / length of credit history: 15 percent / new credit: 10 percent / types of credit used: 10 percent. To qualify for a conventional loan, a borrower must have a credit score above 620. With foreclosure dropping scores by 250-280 points, this becomes increasingly difficult. Check Fig.3.

Tax Problems

While the news is full of the real estate market crisis and of more and more people losing their homes to foreclosure, few realize the tax consequences of such a process. A foreclosure brings about a property title transfer and subsequent tax assessment. Most property owners do not realize that by losing their home to foreclosure, a capital gain tax assessment can be triggered off.

Basically, any time debt is forgiven; it is considered a taxable event. The IRS states that any borrowed money that is not paid back is considered as income and is hence taxable. The way in which the homeowner loses the property will determine the tax consequences of what is referred to as “cancellation of debt” income. A mortgage involves the bank or lender granting funds to the owner in return for a promise to pay the funds back. When the owner begins repaying the money, this money is not claimed as income on their tax return. If, however, this debt amount is canceled or forgiven, it will have to be included as income for tax purposes. The loan amount is considered as income because there is no longer an obligation to repay the lender for the same.

Once the property is finally sold, the tax consequences come in. The original loan was based on the value of the property, but these values keep changing. If the property is sold for less than it was originally worth, and the bank is unable to recover all the money it had lent, the balance is reported to the property owner and the IRS on a Form 1099-C, Cancellation of Debt. This amount is considered as income and must be reported on the homeowner’s income tax form leading to capital gains and income tax applicable.

The only instance where such income is not taxable is when debts are discharged through bankruptcy. Canceled debt tax may apply if the homeowner is labeled insolvent or with reference to certain farm debts and non-recourse loans. These situations however will require the assistance of a tax professional to determine if and when they are applicable.

Buying another Home

Fannie Mae, America’s largest mortgage buyer buys mortgage loans in the secondary mortgage market. Because Fannie Mae ends up holding the properties if the borrowers default, it is instrumental in setting strict guidelines to lessen the chance that a borrower will go into foreclosure in the future. Fannie Mae has recently revised its guidelines and now stipulates separate waiting periods depending on the type of foreclosure (see table below). Overall, it has increased the length of time necessary from the completion of a foreclosure sale until the borrower can get a new mortgage from four years to five years.

But foreclosed owners who can explain the extenuating circumstances — generally situations beyond one’s control must wait for only three years. These could include death, illness, job transfer or accident resulting in severe injury. If there are documented extenuating circumstances, they will have a direct bearing on the number of years to wait to get a conventional loan.

One of the best options for obtaining a mortgage after foreclosure is with a federally insured FHA loan. Three years is the minimum time required between the completions of foreclosure until approval of an FHA loan, irrespective of any extenuating circumstances. Needless to say, FHA borrowers still have to prove good bill-paying habits since the foreclosure for any approval as well. With the worry of qualifying for a new mortgage loan after facing foreclosure, it is imperative to know that with a bit of hard work and dedication, there is a possibility to buy a home again.

A new job

In the event that foreclosure leads to relocation, there are times when a new job hunt is necessary. But unless the job being applied for deals with the direct handling of money, there is no need for foreclosure to be referred to in a job interview. The federal Fair Credit Reporting Act has rules that all employers must follow.

These include notifying a job applicant of running a credit check, and most companies limit checks as a result. The only instance where this does not apply is if a foreclosed owner is applying for a financial job. In such situations, the individual should have a ready explanation about the reasons behind the foreclosure and how the process has changed his or her personal money-management skills as a result.

Emotional costs

There is no possible way to quantify the emotional costs of leaving a home and a neighborhood. From children’s lives being disrupted by being placed in a new school after a move, to the stigma and shame attached to being forced to vacate one’s own home and start anew, the emotional challenges of foreclosure are multifold and far-reaching.

Effects of a foreclosure on a bank

The common misconception that occurs is that the bank automatically ‘wins’ when a foreclosure happens. While, at times the bank does get back the money that is owed, in most cases, the bank loses precious time, money, and resources in dealing with a foreclosure. A foreclosure is an expensive process for a bank after adding up the legal fees, resource expenditures, home maintenance, and real estate taxes. If no one buys the property at the auction, it becomes Real Estate Owned (REO) and taken over by the bank in an attempt to sell the house. During this process, the bank is responsible for the upkeep of the house and any additional real estate fees. Thus, foreclosure has ramifications that extend to homeowners as well as the lenders concerned.

The effects of these failed payments and higher interest extend to other areas of American economy as well. The Work Department has estimated that approximately 100,000 people have lost their job because of the foreclosure crisis. This workforce decrease reduces consumer purchasing power and consumption expenses, which affects the entire economy. Therefore, one can see that the effects of foreclosure are not limited to the lives of the homeowner and his or her family alone. The percentage of sub-prime adjustable mortgages rises to nearly 25% as homeowners nationwide risk foreclosure. Check Fig. 4. For those facing foreclosure, it is important to review all the facts before the event with both the lender and a good tax planner to check which taxes could be triggered off by the process. Pre-preparation and knowledge of the tax laws will make a world of a difference when it comes to minimizing the consequences of a foreclosure.

We, at CESI understand that a foreclosure can be a devastating experience. Apart from legal proceedings and financial difficulties, one is left without a home. We are committed to educating people about mortgage foreclosures and the process of foreclosure to resolve potentially difficult financial situations. Our trained housing counselors can also help with mortgage problems to prevent loss of property. To learn more about our housing and foreclosure counseling services please contact us on our toll free number or register online.