Many Americans, and especially Arizonans, are asking themselves if it is best to walk away from their home rather than to continue to divert significant family funds toward excessive loan payments. Slumping home values and spiking mortgage payments are showing that more Americans than ever are willing to walk away from their underwater homes. While this is a personal decision, current economic times and the expected length of time it will take for the real estate market to recover are important factors to take into account. If you own a house that is worth a lot less than you owe on it, you may want to consider astrategic default.
Strategically defaulting is defined as a decision made by a borrower to stop making mortgage payments (ie defaulting) on the debt despite having the financial ability to make the payment. The home owner is making a deliberate decision to use this financial strategy after analyzing the costs and benefits of defaulting rather than continuing to make payments. In essence, the home owner is deciding to walk away and cut their losses. A strategic default is different from involuntary non-payment due to a loss of job, divorce, disability, etc.
According to a recent MSNBC poll, 78% of people in this country are willing to walk away if it makes financial sense. If 78% of Americans are willing to walk away, where does that leave you? Americans lost $1.7 trillion in home values in 2010 and $1 trillion in 2009 according to Zillow.com. Given this data it appears that most people either have, are currently doing so, or will be strategically defaulting in the future. Where does that leave our real estate market? The market will reset and actually begin to recover faster as more people make this decision.
Consequences to Consider
There are a number of factors to take into account when determining if strategically defaulting is right for you and your family. Below are the factors that arise most frequently:
Financial: Will you be responsible for any of the difference owed between what the property is worth and what you owe on it? This is a tricky question and can have different answers based on your specific situation. In most cases (not all - there are a list of requirements that have to be met), the debt will be forgiven. Arizona is an anti-deficiency state which means lenders cannot sue a person personally for any losses on a home after foreclosure. The property must be on 2.5 acres or less and a single family residence or duplex. Certain other requirements apply so it is important to seek legal, taxation, and Realtor advice prior to assuming that you qualify under this statue.
Taxation: The IRS has the ability to tax on what is considered "phantom income" - income that you never actually received but is taxed. For example, if you owe $300,000 on a home that is only worth $175,000 now, the IRS may consider the difference ($125,000) to be phantom income and may tax you on that income, in addition to your household income, at your individual tax rate. There are ways around this, primarily through the Mortgage Forgiveness Debt Relief Act (MFDRA) or via a claim of insolvency. The MFDRA allows for borrowers to discharge debt on their principal residence through 2012 and up to $2M in forgiven debt. The debt owed normally must be "purchase money debt" which means the outstanding loans on the property have to be the loans that were put into place when the property was purchased. The loans may not qualify if the home was refinanced.
Insolvency is another option for people who do not qualify under the MFDRA. To claim insolvency the debtor must be able to prove that at the time the property was lost the debtors liabilities were larger than their assets.
Again, it is important to speak with your team of trusted professionals to determine how your debt will considered by the IRS.
Credit: Strategically defaulting will affect your credit score but by how much is impossible to say. Credit is complicated to understand let alone compute. The three credit bureaus have not released their "formulas" on computing credit. Credit not only takes into account major impacts such as a foreclosure but it will also report on late or missing mortgage payments. In addition, other credit lines, such as credit cards, car payments, etc, may help to keep the score higher if those line items are reporting positively. It is important to speak with a credit expert prior to making a decision to strategically default to make sure you understand what may happen and to mitigate the negative effects as much as possible in the beginning.
In addition to the logical considerations, many people also struggle with an ethical dilemma. Is it irresponsible? Amoral? Possibly, however what is your family's best financial interest in the long run? Is a homeowner not allowed to take a business approach when making a decision like this -after all a home is also a long term investment. Also, consider this. In the contractual agreement between a borrower and the bank it specifically states what the repercussions would be to the borrower should they default - surrender of the property. The borrower is not escaping that consequence, they are adhering to what is outlined in the contract.
Another interesting tidbit. The Mortgage Bankers Association of America, one of the entities that has continually encouraged home owners to do everything possible to continue to make payments, sold some of its real estate for a considerably lower value than what was owed on it. Its real estate holdings had dropped and the organization determined it was in their best financial interests to remove the bad debt from their books. If big businesses in the industry, who are supposed to be leading by example, are strategically defaulting then why not you?
Making the Decision
If you do decide to strategically default you have a few different options on how best to complete the process.
Short Sale - A short sale is when the seller lists their home for sale with a Realtor and negotiates with the bank to accept an offer that is less than is owed on the property. The greatest advantage to doing a short sale has to do with credit. Typically the seller's credit score will not be as negatively affected as it would with a foreclosure and they will be able to qualify to buy another home in 2-3 years. The seller can live in the home without making payments up until when the house sells. The process will take months (if not over a year) to complete and will require patience and paperwork, however most sellers find that this is their best long term option.
Foreclosure - A foreclosure is where the seller walks away from the home without wanting to put any effort into other options. Similarly to a short sale, the seller can live in the home without making payments up until the house sells at county auction. The negative impact of a "foreclosure" being reported on the sellers credit report can have an extremely detrimental effect on credit score as well as the ability to qualify for anything credit based. In addition, the reporting of a foreclosure on a credit report will typically keep the seller from being able to buy again for 5-7 years.
Deed in Lieu of Foreclosure - A deed in lieu of foreclosure is where the bank allows the seller to basically "give back" the property to the bank and avoid foreclosure proceedings. Unfortunately in our market most lenders are not accepting deeds in lieu, they would prefer for the seller to attempt to short sale the
Strategically defaulting is a personal decision that should be based on one's financial situation and their opinion of the economic times and the real estate market. It is always important to remember to consult with an attorney, accountant, and real estate professional before determining your best course of action with the least exposure for the future.
Thanks to Alyssa Samuelson, CDPE, CRS, ABR, SFR, GRI Scottsdale, AZ for sharing what is happening in Arizona.
Give me a call if you are concerned...walking away isn't really a sound strategic move!!