Roland P.
Reynolds, Esq. of The Wolf Firm (Servicing Management Magazine April 1995)
Roland P.
Reynolds, Esq. of The Wolf Firm
(Servicing Management Magazine April 1995)
The newest twist in the industry serving distressed borrowers comes predictably from
California where companies with names like Boston Harbor Corporation and New England
Financial are promising borrowers that they can walk away from their mortgages without
consequences.
Only active in the state for approximately 18 months, these companies have suddenly become ubiquitous, advertising heavily on radio and in print. Perturbed lenders have begun recelvlng phone calls and letters from their borrowers statlog that they have deeded away their property and will no longer make payments.
The pitch to borrowers by these companies is uniform and essentially two-pronged. The company will:
In most cases, these companies appear to be overpromising what they can deliver, or to be simply misleading the borrower. The cost to the borrower is usually 1% of the original principal loan balance.
Boston Harbor's transfer
Boston Harbor's program is typical. Boston Harbor is run chiefly by lawyers who emphasize their legal background heavily throughout their promotional literature.
(Although Boston Harbor tells its customers to consult the customer's own legal and tax professionals, throughout its video Boston Harbor leaves the distinct impression that the lawyers are rendering their legal opinions to the customer.) For 1% of the original loan balance, Boston Harbor will take a deed to the property and then market the property and negotiate with the lender for a short payoff.
The position that the transfer of the property to Boston Harbor will be sufficient to avoid cancellation of debt income is considered by many to be a very aggressive stance.
Tax on cancellation of debt income is created as follows:
In the event of a short payoff of foreclosure, a borrower whose loan is non-recourse will usually be taxed by the IRS on the difference between the sale amount and the outstanding loan balance. The IRS labels the amount of this difference as "debt relief" and taxes it as income received. Of course if the value of the property exceeds the debt, there is no cancellation of debt Boston Harbor represents that it can eliminate the tax burden.
A True Sale?
The program works as follows:
Boston Harbor takes a deed to the property and records it as a sale in the amount of the loan balance that is outstanding. In the event of a short sale, Boston Harbor records a loss. This loss is in the same amount as the phantom "debt relief" income, thereby canceling it out.
For example, Boston Harbor takes title to a property worth $90,000 encumbered by a loan with a balance of $100,000. Then Boston Harbor negotiates a short sale with the lender for $90,000, and at the time of the sale incurs a $10,000 "loss." The loss cancels out the $10,000 in debt relief.
This scenario sounds appealing, but it is based on the premise that the IRS will accept form over substance.
Whether the so-called sale will be treated as such by the IRS is an open question. Certainly, the transfer lacks some of the indications of a true sale.
For instance, the original borrower continues to occupy the property rent free after the transfer to Boston Harbor. The IRS is reportedly warning borrowers that it will reserve the right to demand that the borrower pay the debt relief tax.
Importantly, not every borrower is subject to tax on debt relief. If the debt is nonrecourse, no debt relief tax would be owing. Also, the insolvency of the borrower may decrease the debt tax relief.
Doesn't shield borrower
Further, some of the statements in Boston Harbor's promotional materials appear to be incorrect.
For example, in a video emphasizing his background as a real estate attorney, Boston Harbor CEO Eric Fugan states that after the short sale the borrower will not receive a Form 1099 reporting taxable income. This is simply wrong; the borrower will receive a Form 1099.
Also, these companies' programs can do nothing to shield borrowers from a deficiency judgment when the debt is recourse. Although judicial foreclosures seeking deficiency judgments are rare in California, they do occur, and these companies do little to highlight may be a real risk.
Nor do the tax issues stop there. When Boston Harbor negotiates a short sale, the borrower may incur significant capital gains, depending on his basis in the property. In fact, if the sale to Boston Harbor from the borrower is valid, the borrower may increase his capital gains by participating in the Boston Harbor program.
For instance, suppose a borrower has a basis of $50,000 in a property worth $100,000 with a debt of $120,000. The borrower arranging the short sale himself would incur $50,000 of capital gains. But if the borrower has sold the property to Boston Harbor for $120,000, the capital gains is $ 70,000.
These types of tax issues simply are not given sustained examination in the application process that these companies typically ask the borrowers to complete.
Imply credit relief
The second benefit that these companies heavily promote, but do not guarantee, is relief from derogatory credit reports.
The companies imply that they will use their expertise to negotiate short sales with lenders, but that even if this fails and a foreclosure ensues, it is highly unlikely that a foreclosure will appear on the borrower's credit record.
New England Financial's corporate counsel, Andrew M. Smith, tells borrowers in "the vast majority of cases, the foreclosure is either deleted from the homeowners' credit report or never entered." Credit reporting agencies have stated that, in fact, the negative credit report is not deleted without the lender's authorization.
Also, the servicing guidelines from both Fannie Mae and Freddie Mac require that the lender report the foreclosure under the borrower's name thus precluding the lender from ever considering not reporting the foreclosure.
The prospects for these companies to negotiate short sales also appear to be dim.
In most cases, the unauthorized transfer of the property by the borrower is a separate event of default under the loan documents. Thus lenders are often hostile to negotiating a short sale with a new entity they perceive having been brought by the borrower to help the borrower avoid his obligation to the lender.
One company, Homes America, has reportedly negotiated only three short sales out of the two dozen properties it has acquired.
How much benefit?
The cost of receiving questionable benefits can be substantial for the borrower. Boston Harbor charges 1% of the original loan amount, with a minimum of $1,000. But, says CEO Fagan, when you transfer the property to Boston Harbor, "your cares about this property are over."
Whether the property has to be lost at all is not an issue that Fagan raises. In his video, Fagan tells borrowers who can't make their payments that they have only two choices a short sale or foreclosure. In fact, loan modifications, forbearance agreements and deeds in lieu of foreclosure are all options open to many borrowers.
Some critics have voiced concern whether these companies are fully licensed and giving borrowers all of the disclosures that they are entitled to receive under California law.
The office of the Los Angeles District Attorney has reportedly begun research into the practices of these companies.
A clear definition
In California, statutorily defined "foreclosure consultants" must give clients a number of disclosures, including written notice of a three day right to cancel the contract and notice that no money can change hands until the consultant finishes doing everything he said he would do.
Under California Civil Code S2945.1, a foreclosure consultant includes any person who makes any solicitation, representation or offer to any owner to perform for compensation, among other things, the following:
This definition appears to make these companies subject to the rules of foreclosure consultants.
Further, Boston Harbor may have to be licensed as a real estate broker. California Business and Professions Code section 10131 includes in its definition of real estate broker one who "solicits borrowers or lenders for or negotiates loans or collects payments or performs services for borrowers or lenders or note owners in connection with loans secured directly or collaterally by liens on real property.
This definition would appear to include the activities conducted by Boston Harbor. In short, borrowers would be well advised to approach such companies warily. They may not be able to deliver the supposed tax benefits nor ameliorate the borrowers credit problems. Borrowers expecting relief should first consult with tax, legal or financial advisors of their own choice before making any commitments.
For further information please contact:
The Wolf Firm, A Law Corporation, is an "AV" rated law firm which concentrates on providing superior legal services to the mortgage banking industry. The firm's national clientele includes many of the largest mortgage bankers in the country, as well as a variety of savings banks, commercial banks, commercial finance companies, credit unions, and the Resolution Trust Corporation. With a staff of approximately forty individuals, including attorneys, certified paralegals, legal secretaries, administrators, clerical personnel, and a full time computer systems analyst, the firm represents its clients on a wide range of matters including all aspects of both residential and commercial/multifamily mortgage loan origination and servicing, securitization, regulatory compliance, bankruptcy, and litigation related to the foregoing in both federal and state courts throughout California. For more routine matters, such as residential bankruptcies, evictions and receiverships, The Wolf Firm has developed extremely cost-effective and efficient programs using specially trained paralegals and computer technology to assist its attorneys in handling these matters at rates that are the most competitive in the State of California and, through its membership in the USFN, the Firm is able to arrange similar services in virtually every state in the nation.
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