Distressed Real Property Your Options
Author: Michael Mogil, P.A.
Southern Beaufort County is among the hardest hit regions in the national real estate price crash. Property values here increased more than the national average in the preceding decade, and the area is dependent on discretionary purchasing of second homes, retiree relocation, and a continuously growing economy. Speculating in real estate was a local pastime throughout the growth years, such that a disproportionate number of locals owned more than one property subject to a mortgage. The combination of a dramatic cut back in local employment in the construction sector over the past three years, combined with the near elimination of lot loans, no doc loans and 90 to 100 percent loan financing has caused supply of properties for sale to far exceed demand. Prices have fallen locally between 35 and 80 percent from the 2005-2006 highs, depending on the type of property and location. Thus, distressed loans and foreclosures remain at historically high rates.
For many locals, whose income is dependent on retirement account portfolios or directly related to businesses and jobs involving real estate transactions and construction, (e.g. builders and tradesmen, brokers, lenders, transactional professionals and staff), or the national economy, this means income plunged at the same time as market prices have severely declined. People have higher mortgage payments and less cash to pay the servicing of loan(s) which often exceed the value of the secured property. And they cannot quickly sell. If you are faced with this situation, what are your options?
Your first decision is whether to keep the secured property or let it go. Surprisingly, many people are, in fact, choosing to “let go,” because either they have exhausted their resources servicing principal debt for years or they are making a calculated decision based on their guess that property values will take a long time to recover such that the short-term credit score or liability ramifications of missing mortgage payments are not significant enough to justify the continued expense of carrying property.
The term “strategic default” has become popular jargon. Our office advises people working their way through the maze of possibilities raised by a mortgage default, but the remainder of this article will focus on the options available to people who want to keep their properties despite the current weak market.
Starting with the assumption that a primary residence confers benefits beyond the potential profit upon sale, such as tax deductions, flexibility in living arrangements, and stability, there is value in trying to keep your property. Under most existing conventional loan programs, borrowers who default on their existing mortgage loans may be barred from obtaining a new conventional loan in the near term—three to seven years. Thus, keeping property and the underlying loan remains the favored option for many.
Under current market conditions, an “upside down” owner who cannot easily continue to pay has the following options, each of which trigger difficult decisions: 1) Continuing paying the loan according to the contract; 2) loan modification; 3) short sale; 4) default; and 5) bankruptcy protection. The analysis below is really not relevant to owners who have significant equity in their mortgaged properties; in those instances, a sale at market price will quickly resolve financial considerations. Here are the alternatives:
CONTINUE TO PAY
The first option for an “upside down” owner is to continue paying the loan according to its contract terms. This option preserves credit rating and delays other potential negative consequences of default such as entry of a money judgment or the undesired income tax allocations. Each individual case raises unique life circumstances that factor into this decision, but for a primary residence, my general rule of thumb is that it usually makes sense for a borrower to continue paying if the ongoing household income is sufficient to meet the mortgage and life obligations or if the responsible parties have substantial, non protected (IRA, 401k) savings that will not be meaningfully reduced by a short-term negative cash drain caused by a mortgage they cannot afford.
Loan modification is the process of restructuring a mortgage loan, either temporarily or permanently, to reduce interest, payments, principal or any combination of those factors. Loan modification usually involves the deferment or cure of missed payments to the end of the loan. Loan modification is negotiated with you directly by lender servicing agents. The first thing you should know is that even with federally sponsored initiatives, loan modification is a voluntary process on both sides, and absent unusual circumstances or under certain bankruptcy situations, no lender has a legal obligation to modify a loan. Thus, borrowers attempting to modify experience the frustration of lengthy and repetitive exchanges of information, trial modification periods, and often the ultimate rejection of the modification. For the owner, modification can be a salvation. I have had clients whose mortgage payments were reduced 30 to 50 percent over the term of their loan, allowing them to keep their homes. I recommend participating in the modification process if you want to keep your property. A few additional caveats: Most modifications have not been approved. This summer, a West Palm Beach convention attracted more than 5,000 participants from around the country who shared their stories and experiences with loan modification. At the time, statistics demonstrated that only one in five first mortgages was successfully modified.
Who succeeds and who does not is not immediately predictable, because the process is dependent on a number of variables such as the lender, the applicable federal and private programs, property value, the borrower’s financial condition and timing. I highly recommend against paying large fees to third party modification companies, particularly those who are out of town or who advertise on late night TV, the radio or the Internet. I am not aware of any clients who paid $3,000 or more to a third-party company to modify their loan and reached a successful result. Finally, many modification programs require that the borrower be in default, meaning that they miss payments prior to being considered. Thus, the borrower usually must damage his credit rating and expose himself to the foreclosure process before he can modify.
What about loan principal reduction programs reported in the media? There are federally based incentive programs which my firm has not yet encountered in actual practice. And there are voluntary troubled debt restructure programs (TDR) that lenders implement on a case-by-case basis. Principal reduction is a possibility but not a current reality in most situations.
A short sale is when a property sells for a price that is less than the sum of the mortgage, judgment and other liens encumbering the property. The lenders and judgment holders agree to release their liens for less in order to receive cash at a closing, near term. Under current market conditions, many properties can only sell at short sale prices, or after foreclosed. A short sale often (but not always) requires that the seller be in default under its loan(s). Our office is involved with a large number of short sales. There are a number of anticipated results: 1) The lien holders reject the sale or the first lien holder accepts the sale but the second lien holder does not. Normally, that is the end of the transaction and the owner still owns the property; 2) the lien holder(s) agree to release their liens but reserve rights against the borrowers for the balance not paid off; 3) the lien holders agree to release their liens and underlying claims for present cash payment and issue a 1099 income allocation for the difference or; 4) the release specified in number 3 is negotiated with the borrower/seller having to make additional payment at closing.
Tax consequences associated with short sale must be discussed with a tax professional, because they involve the application of a 2008 federal homeowner relief law, capital gains, and ordinary income. Short sales are usually complicated negotiations. Many local Realtors have been trained to assist sellers and buyers through this process. Our office also counsels clients in these matters and acts as settlement agent in short sale transactions. We also work with third party negotiators and specialists.
The primary consideration before entering a short sale which is often overlooked is the question of whether you want to keep your property. Short sales often delay foreclosure and avoid some of the credit and emotional consequences of foreclosure, but ultimately, short sale results in another person owning your property; thus, you lose its use and its long-term benefits.
Default occurs when the borrower stops paying the mortgage, or in the case where there is a first or second mortgage, one or both. The first consequence of default is a negative credit score hit. Then expect repeated contacts from the lender to coerce payment, styled as efforts to work with the borrower to determine the cause of the default and its potential resolution. Ultimately, if the default is not cured and the loan not modified, the lender forecloses (or in the case of investment properties, may simply sue on the note). Foreclosure in South Carolina is a judicial process that takes a minimum of 90 days. A borrower can defend the lawsuit, asserting actual defenses to the loan or payment schedule, or procedural rights available to delay the foreclosure for a short period of time. As a practical matter, nationally, foreclosures are taking more than 90 days, and the most recent data I read says that the foreclosure process is averaging between 350 to 425 days from the date of the first missed payment until foreclosure sale. After foreclosure sale, the lender, or a third party, owns the property and the prior owner has a very short window to vacate, usually less than 30 days.
Last week Chase, Bank of America and other lenders announced that they are freezing foreclosures in 23 states, including South Carolina, due to the discovery that employees who signed affidavits used in foreclosure to quantify and document loan defaults did not actually read the underlying computer generated loan files. In South Carolina, affidavits are only used where the borrower consents, or in cases where borrowers default, i.e. do not file answers to the foreclosure lawsuit. Here, the practical impact of the current freeze will likely be to delay foreclosures initiated by the national lenders for only a few months since nearly all loans in foreclosure have been in default for many months. This issue reinforces, however, my recommendation that if you are facing foreclosure, you retain an experienced attorney to advise you of your legal position and to take whatever protective measures are available.
The post sale consequences of foreclosure are largely dependent on whether the subject property was primary residence property and whether the lender or lenders seek a deficiency money judgment. Lenders consider property values, federal subsidies, mortgage insurance considerations and the borrower’s ability to pay in making deficiency determinations. Tax considerations and asset protection are primary issues we usually discuss with clients in this area.
Bankruptcy reorganization through a Chapter 11 or Chapter 13 case offers owners the ability to stop foreclosure proceedings up until the very day of foreclosure sale, and potentially cure their loan account(s) by resuming ongoing payments and making up the missed payments and account fees, called arrearage, over a plan period of three to five years. Chapter 7 bankruptcy is also available to discharge debts, and stay foreclosure in the short term, but a debtor in Chapter 7 cannot force a lender to accept a long-term repayment plan. Thus, Chapter 7 is not usually employed where a property that an owner desires to retain is subject to loan default. Bankruptcy, be it Chapter 11 or 13, is a powerful tool that can give borrowers/owners a fresh start and, alternatively, may address and discharge the judgment and tax consequences caused by owning distressed real estate. Bankruptcy can also, in unique circumstances, convert junior liens into unsecured debt and eliminate certain judgment liens, freeing future equity in property. Bankruptcy considerations include the impact on a debtor’s business and his/her personal property and long-term goals. Bankruptcy does not, under current law, discharge any debts which accrue after the date of filing a case, which means that regime and POA fees that accrue after bankruptcy filing but before foreclosure sale are often not discharged in a bankruptcy case.
Loss of income and ownership of distressed real estate raises issues and decisions that many local residents did not anticipate having to address. This article is not intended to confer legal advice related to any specific situation. Please contact our firm in confidence should you have any specific questions in this area.
To comment or for further information, contact Michael Mogil at firstname.lastname@example.org or call (843) 785-8110.