The American Nightmare

Regardless of which party is in power the new preferred method of regulation from Washington is through the tax code. As a result it is important for any attorney to understand basic tax issues even if you refer clients elsewhere. With new client opportunities in the tax field you may want to consider volunteering with Administer Justice for experience to help clients who cannot afford professional help and to gain valuable skills to represent those who can afford such help. Visit www.administerjustice.org, call 847-844-1100 or e-mail our volunteer program services coordinator Teri Jacobs at tjacobs@administerjustice.org.

1. Buying into the American Dream. The American Recovery and Reinvestment Act of 2009, 26 USC 1001. The economic stimulus act contained a provision in Section 1006 for a refundable first-time home buyer credit.

What is it? A credit on taxes for buying a home. That’s a government give away.
Who can get it? Any U.S. Citizen or Resident Alien buying a home for the first time after April 9, 2008. No ITIN holders.
How much is it? Up to $8,000 (10% of the purchase), but if you sell the home within three years you must repay the money.
How do I get it? Apply for it on your 2009 taxes. If purchased in 2008 under former interest free loan provision can file 1040x to amend.
Is there a cut off? The credit phases out for incomes over $75,000 ($150,000 for married couples).

2. Keeping the Dream Alive.
Illinois – Homeowner Rights Act, 735 ILCS 5/15-1504.5, effective 1/1/09.
Attorney General – Homeowner Helpline (866) 544-7151.
"We have repeatedly found that these foreclosure rescue operations are swindling desperate homeowners out of money they can't afford to lose," said Attorney General Madigan. "Struggling homeowners need to know that free help is available. The 24 lawsuits I have filed prove foreclosure rescue operators don't help. They don't call your lender, they don't modify your loan, and they don't represent you in court if you're in foreclosure. All they do is take your money.”

Federal – Making Home Affordable, www.makinghomeaffordable.gov (Feb. 18, 2009); Hope for Homeowners and Second Lien Program (April 28, 2009).
• Modifies loans to 38% of income then pays lender to reduce to 31% of income. Interest reduced to as low as 2% and if still not at target level can extend to 40 years
• Only owner occupied home, do not need to be in default.
• Capped for five years then can adjust 1% per year until reach conforming loan survey rate
• Servicers receive $1,000 fee to process plus $1,000 per year for up to three years for every loan sustained over that time.
• If borrower stays current they receive $1,000 each year for five years.
• If borrower can’t meet eligibility then they can receive a $1,500 relocation payment to help effectuate a short sale or deed-in-lieu of foreclosure.
• Mortgage must have originated before January 1, 2009 and new borrower will be accepted until December 31, 2012.
• Any foreclosure action is temporarily suspended during a trial period to allow a homeowner to determine if a foreclosure alternative is available.

Example – Harry Homeowner purchased a home in 2004 for $159,700 (the average home cost 2000 census). He and his wife, Halle both worked earning $59,351 (the average household wage, 2000 census). The principal, interest, PMI and tax monthly payment is $1,620. Halle loses her job and the household income is now $30,394 (average per person income). This is how the loan modification program would work.

This is a significant modification. In addition to saving $10,020 a year in payments, Harry and Halle will receive $1,000 per year for five years for a total savings of $50,100 in reduced payments and $5,000 in incentive payments. How these incentive payments will be reported and treated from a tax perspective is yet to be determined.

3. A recurring nightmare. Mortgage Forgiveness Debt Relief Act of 2007, 26 USC 108(a)(1)(E).

The first wave of foreclosure – losing your home. The effect of the Obama plan on foreclosures is not yet known. What is known is the seriousness of the foreclosure nightmare:
• Illinois ranks third in the country for mortgage fraud (Mortgage Asset Research Institute Report, March 2009)
• Kane County has a 9.8% unemployment rate (Feb. 2009) which is higher than Chicago and the surrounding suburbs.
• Kane County has the second greatest foreclosure increase in the Chicago area – up 115%.
• Kane County leads the collar counties with a 16% asset poverty rate meaning a household with less than three months poverty level savings.
• 25.5% of Kane County is below 200% of the poverty line or 127,760 people.
The second wave of foreclosure – Just when you thought it could not get worse the tax man cometh.

Example: Fred Krueger and his wife, Nancy Thompson, purchase a home in Winnebago County in 2004 for $335,000. They put $15,000 down and financed the remaining $320,000. In 2006, Fred and Nancy refinance for $350,000 and use $30,000 to pay off credit cards and pay for college tuition for their daughter. The fair market value of the property was $380,000. In 2008, Nancy leaves the home, moves to Kane County and files for divorce. Fred is depressed and loses his job. Craven Bank forecloses on the property which now has a payoff of $345,000 and a fair market value of $300,000.

Nancy receives a 1099-C on the Elm Street property in February 2009. The form is attached. Proactive discovery forms from the divorce proceeding are used to complete the attached insolvency worksheet. Nancy comes to you for help.
How can you save Nancy Thompson from Freddy Krueger and the Nightmare on Elm Street?
 
Cancellation of Debt – Internal revenue code (IRC) Section 61(a)(12) includes in gross income “income from discharge of indebtedness.” Could be credit card, auto repossession, foreclosure or other.

Form 1099-A is an informational form used by a lender to indicate they have acquired an interest in the property.

Form 1099-C is the form to report cancelled debt of $600 or more.

Practice Tip: Examine the 1099-C for correct listing of debt in box 2 and review box 7’s fair market value. If either of these is incorrect contact the lender to try to get a corrected 1099.

In the example box 2 incorrectly list the entire debt - $345,000 – instead of $45,000.

Next step is to see if any exceptions or exclusions apply. In doing so ordering rules set forth at 26 USC 108(a)(2)(C) apply. Importantly the principal residence exclusion takes precedence over the insolvency exclusion unless the taxpayer specifies otherwise.

Exceptions: Amounts otherwise excluded from income
Certain student loans
Deductible debt, for taxpayers using the cash method of accounting, and
Price reduced after purchase

Exclusions: Bankruptcy (Chapter 11)
Insolvency
Qualified Farm indebtedness
Qualified real property business indebtedness
Qualified principal residence indebtedness, and
Certain non-business debt of a qualified individual because of the Midwestern disasters.

In the example Nancy will not have any exceptions but may have three possible exclusions:

Insolvency - Nancy and Fred had $45,000 in cancelled debt income. In completing the insolvency chart the extent of insolvency (line 40) is $20,000 which would leave $25,000 in cancelled debt income. This is probably not a good choice.

Qualified Principal Residence –
According to IRC Sec. 163(h)(3)(B) debt incurred in acquiring, constructing or substantially improving a principal residence and secured by the principal residence and either there is a decline in the principal residence’s value or in the taxpayer’s financial situation. Not included is debt unrelated to the principal residence – no home equity loans or use of funds for other purposes. The debt must be discharged on or after Jan. 1, 2007 and before January 1, 2013.

In the example Nancy had $45,000 in cancelled debt income but $30,000 is credit card debt so she can only exclude $15,000, leaving $30,000 in cancelled debt income.

Non-business debt of a qualified individual because of the Midwestern disasters -
Publication 4681 and Publication 4492-B lay out the exception for areas affected by flooding between May 30 and July 31, 2008. Table one list states and counties which can exclude COD income in all circumstances while table two has limited circumstances and requires damage proof. In Illinois table one includes Adams, Calhoun, Clark, Coles, Crawford, Cumberland, Douglas, Edgar, Hancock, Henderson, Jasper, Jersey, Lake, Lawrence, Mercer, Rock Island, Whiteside, and Winnebago Counties.

In the example the home is located in Winnebago County and the foreclosure took place after June 1, 2008 and before January 1, 2010 so Nancy could exclude the income on that basis. In this case a natural disaster seems to have spared her from a tax disaster. She will still need to calculate gain or loss on the worksheet on Form 982 which she needs to complete and file with her return. In this case she has a loss of $35,000 (purchase price – FMV at time of disposition), but with a principal residence the exclusion under section 121 of the tax code would likely apply.

Final Note: Congress is not done in this area and new provisions may be passed. The National Taxpayer Advocates report to Congress contained recommendations concerning cancellation of debt including removing taxpayers with modest amounts of debt cancellation from the COD regime; providing an insolvency worksheet for taxpayers (this was done in April and is the sheet used in these materials); and creating a centralized unit in the IRS dedicated to handling COD issues.