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Suzanne Macdowell's Blog

By Suzanne MacDowell | Agent in 07856

A cautionary tale for underwater homeowners - to rent or not to rent?

One issue that is often over looked by underwater homeowners is the Mortgage Tax Relief Act of 2007.  Normally, forgiven debt is treated as income by the IRS and the amount forgiven is taxed at your regular tax rate.  In other words, if a lender forgives $100,000 of debt, and you are in the 28% tax bracket, you will be responsible to pay $28,000 in income tax on the forgiven debt.  This became a HUGE issue for homeowners who needed to short sell their home!  So, in 2007 the government carved out an exception for underwater homeowners.

 

However, the act does not apply to ALL property owners. If the property is a rental property the act may not, in fact probably will not apply.  This subtlety in the law is very, very important for underwater homeowners who are considering renting their property rather than short selling. 

 

Underwater homeowners are rightfully concerned that a short sale will have a negative impact on their credit score, and it will.  However, the biggest damage to the credit score comes not so much from short selling the home as from missing payments.  If a homeowner can keep the payments current while negotiating the short sale the impact on their credit score can be kept fairly minimal.  If an underwater homeowner decides to rent their current home in order to either buy or rent another home, however, the impact could be potentially devastating. 

First, depending on how much value the original home has lost, it could take years for the home to recover enough of its value for the owners to be able to sell without short selling.  Second, the business of ‘landlording’ is just that, a business and not one for the faint of heart.  Even in the best of neighborhoods you can run into issues with tenants who pay their rent late, or don’t pay at all and have to be evicted, or don’t take care of the property, or refuse to obey association rules.  And worst of all, if the underwater owner decides to short sell AFTER the property has been re-classified as a rental property, they may not be able to take advantage of the tax relief at all.  

 

I actually know of one case where this happened.  The underwater owner listed a rental property as a short sale.  The bank was prepared to forgive $200,000 in debt.  But when the owner realized he would be responsible for $56,000 in income taxes (assuming a 28% tax bracket), he canceled the short sale.  Instead, he will have to continue to rent the home.  He will lose money every month because the rent does not cover the full amount of the mortgage.  And this situation will likely go on for years and years as he waits for the housing market to recover. 

 

If you owe more than your home is worth, and you are considering renting the home rather than short selling, you need to weigh this consideration very carefully.  How long will it take for you to repair your credit rating versus how many years will you need to be a landlord while waiting for the market to recovery?  Can you handle the risk and the work involved in being a landlord?  Are you willing to sacrifice your time?  Will the rent cover the mortgage or will you continue to lose money every month?  What if you CAN’T handle this new role, landlord?  What will the tax consequences be if you change your mind?  It may actually be more desirable, in the long term, to short sell the home than to be stuck with a whole new career as a landlord together with all the headaches, and an income tax liability too.

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