By: Roland P. Reynolds
of The Wolf Firm
By: Roland P. Reynolds
of The Wolf Firm Reprinted with permission from Servicing Management Magazine, April, 1995, copyright 1995, all rights reserved. Subscriptions at $48 per year are available from Servicing Management, fax (203) 755-3480.
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 20 months, these companies have suddenly become ubiquitous, advertising heavily on radio and in print. Perturbed lenders have begun receiving phone call and letters from their borrowers stating that they have deeded away their property and will no longer make payments. One of the companies has been sued by the California Attorney General for false and misleading business practices.
The pitch to borrowers by these companies is uniform and essentially two pronged: The company will arrange for the borrower to avoid otherwise taxable cancellation of debt income (sometimes called debt relief income) and will shield the borrower from negative items on his credit record. Some companies imply the borrower will be relieved of further liability on the loan. 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 program is typical. Boston Harbor is run chiefly by lawyers who emphasize their legal background heavily throughout their promotional literature. (Although the 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 one percent 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 a 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 or 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. 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 cancelling it out. For example, Boston Harbor takes title to a property worth $90,000.00 encumbered by a loan with a balance of $100,000.00. Boston Harbor negotiates a short sale with the lender for $90,000.00, and at the time of the sale incurs a $10,000.00 "loss." The loss cancels out the $10,000.00 in debt relief.
This scenario sounds appealing, but it is based on the premise that the IRS will accept form over substance. It appears unlikely that the sale will be treated as such by the IRS. On January 11, 1995, the Los Angles office of the IRS issued a news release with the heading: "HOMEOWNERS BEWARE! IRS WILL NOT RESPECT 'SHAM' PROPERTY TRANSFERS TO AVOID TAXES ON FORGIVEN MORTGAGE DEBT." The news release describes in generic terms the Boston Harbor program and concludes "The plan doesn't work. The transfer of the property to the company is not a bona fide sale...." Certainly the transfer lacks some of the indicia of a true sale. For instance, the original borrower continues to occupy the property rent free after the transfer to Boston Harbor.
The California Attorney General has taken the position that Boston Harbor's business practices are false and misleading. According to Deputy Attorney General Dennis Dawson, the Attorney General has filed a complaint against Boston Harbor in the San Diego Superior Court alleging that claims by Boston Harbor that it can shield borrowers from debt relief tax, preserve and maintain borrowers' credit and help borrowers avoid any further liability on their loans by virtue of the property transfer are false and in violation of Business & Professions Code section 17500. The Court has not yet made any ruling in the lawsuit, and the parties are negotiating.
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 relief tax. Some of the statements in Boston Harbor's promotional materials appear to be incorrect. For example, in a slick video emphasizing his background as a real estate attorney, Boston Harbor CEO Eric Fagan 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 what may be a real risk.
Nor do the tax issues stop there. When a 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. Suppose a borrower has a basis of $50,000.00 in a property worth $100,000.00 with a debt of $120,000.00. The borrower arranging the short sale himself would incur $50,000.00 of capital gains. But if the borrower has sold the property to Boston Harbor for $120,000.00, the capital gains is $70,000.00. These sorts of tax issues simply are not given sustained examination in the application process that these companies typically ask the borrowers to complete.
The second benefit that these companies heavily promote, but doe not guarantee, is relief from derogatory credit reports. The companies imply that they will use their expertise to negotiate short sales with lenders, but 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. In fact, both Fannie Mae and Freddie Mac servicing guidelines require that the lender report the foreclosure under the borrower's name, thus precluding the lender from even considering not reporting the foreclosure.
The prospects for these companies negotiating 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 that they perceive having been brought in 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.
The cost of receiving questionable benefits can be substantial for the borrower. Boston Harbor charges one percent of the original loan amount, with a minimum of $1,000.00. But, says President Eric 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. In California, statutorily defined "foreclosure consultants" must give clients a number of disclosures, including written notice of a 3 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 \2945.1 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: stop or postpone a foreclosure sale, avoid or ameliorate the impairment of the owner's credit resulting from the recording of a notice of default or conduct of a foreclosure sale, and save the owner's residence from foreclosure. 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 these 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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