Your Home Loan Mortgage Just Disappeared?

In the past few weeks in my Los Angeles, California practice, I have had several potential (and existing) clients tell me that the bank which holds the junior mortgage (e.g. 2nd or 3rd trust deed)  on their house has suddenly forgiven the debt and voluntarily released their lien against the property.   What is even more astounding about this is that it is being done without the borrower even requesting it–the banks are just doing it on their own!   Typically this is the kind of result we lawyers can achieve for bankruptcy clients by doing what is known as a “lien-strip” in a Chapter 13 case where the value of the property is less than the amount owed to the first mortgage.

Unfortunately, such a gift may have significant unforeseen consequences to the borrower whose loan is being forgiven.

What About Taxes?

As Shakespeare wrote in Hamlet, “Aye, there’s the rub”.   While it’s very magnanimous, if not commendable, for banks to voluntarily forgive these debts and release their liens, it’s not without cost to the borrower/homeowner.     In many cases, forgiveness of debt is taxable income according to the Internal Revenue Code (26 U.S.C. 108),  so you can imagine what kind of  tax liability you might end up with if your bank suddenly forgives a $100,000 loan.  There are exceptions to this, the main one being that if you are insolvent on the date the forgiveness occurs, then there will be no increase in your taxes as a result–and many people will fall under this exception–but not everyone.   If you are in this situation where your junior mortgage liens are “under water” you should first consult with your accountant to determine what, if any, tax liability might result in the event the bank(s) suddenly forgive your debt.

It is important to compare the advantages of a possible bankruptcy with the potential tax debt incurred if no bankruptcy is filed, because once you owe the taxes, they will not be dischargeable in any bankruptcy case–at least not for several years.

Bankruptcy Can Still Help

One of the many benefits of bankruptcy is that forgiveness of debt, such as described above, does not become taxable income to the debtor in bankruptcy.    The amount forgiven can, however, be used to reduce certain tax attributes the taxpayer may already have, such as net operating losses, business credits, carryovers and the like, but it will not result in any additional income subject to taxation.

However, in order to obtain this benefit, the bankruptcy must be filed before the debt is forgiven!  That is why filing a Chapter 13 and eliminating your mortgage liens through a bankruptcy proceeding may be less expensive and a better alternative than simply waiting for the unexpected largesse of your bank.

As always, the earlier you get advice to learn about your options, the better able you will be to maximize your benefits and minimize your costs.


Image Courtesy of Numismatic Bibliomania Society