Strategic Default [on a property]

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Slowmaha
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Strategic Default [on a property]

Post by Slowmaha »

Moral issues aside, at what point would one consider a strategic default on a property?

Situation:

My brother purchased a condo at the top of the bubble, later got married, got out of the military, and moved out of state. The condo is STILL 25-30k under water 8 years later. He currently has a renter that covers the mortgage interest, but that's about it. The proverbial straw may have come last week when the condo HOA hit him with a $4,500 special assessment due in Nov.

He has paid faithfully for 8 years but is considering doing a strategic default to unleash this albatross. His credit otherwise is excellent.

Has anyone had to make this decision? I'd be curious to hear your take.
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mojave
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Re: Strategic Default

Post by mojave »

Unfortunately I am an expert on this topic. In 2007 my then-single husband, at the age of 22, was making six figures and bought a townhome. Market and housing collapses. He is in construction and his income dropped 40%. Years of struggling ensues. We get married (I did not have my name on the townhome) and did a short sale because the struggle was great and savings was pretty much zero because it was all going towards bills and a mortgage that we couldn't afford, even with my income.

The remaining mortgage amount was ~$210k, it sold for $85k.

It made sense for us at the time because the Mortgage Debt Forgiveness Act was in place, which meant that you didn't have to pay taxes on the forgiven amount. That act is no longer in place. What this means is, if that act was not in place and he sold the house, he would have to pay taxes on $125k, the difference between the remaining loan amount and the sale price, because it is considered income to the IRS. People still can claim insolvency to avoid that today, however. But I know nothing about claiming insolvency.

Also, short sales are not easy to get approved. You have to prove that you are in a hardship and that can be very difficult to do.

EDIT: another thing, depending on the home state, even after completing a short sale the lender can go after you for the remaining difference, the "deficiency". You actually have to have the lender state in their short sale acceptance letter that they are forgiving you completely of the deficiency or else you risk them coming after it some day down the road.

Do not underestimate the blood, sweat and tears that goes into a short sale.
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jimb_fromATL
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Re: Strategic Default

Post by jimb_fromATL »

Here are some sort-of random things he may want to think about:

First, IMO "strategic default" is just a way to pretend that defaulting on your promise to pay a debt is somehow OK if you call it something else. It doesn't relieve you of the legal (or moral) responsibility to pay people what you borrowed and promised to pay back with interest just because it's no longer convenient for you.

He also needs to realize that his credit rating will be ruined for a minimum of 7 years, and the default will always be a public record that can haunt him if he ever needs to borrow money for anything else in the future.
  • A short sale is not something he gets to choose, by the way. It's the lender's choice, and they're not likely to consider it until he has defaulted on the loan for a long time. Then, if they feel that he does not have enough income or assets worth pursuing, they may choose a short sale to make it a little easier to get their property back ... with lower legal costs. If he has income and assets, they're much less likely to be interested in letting him walk away easy while they and their investors and shareholders take the loss.

    By the way, a short sale is still roughly equivalent to a foreclosure or deed-in-lieu of foreclosure, and will adversely affect his credit rating by about the same amount as a foreclosure.
Next, while some states are "non-recourse" for mortgages, in that the lender can only take back the property that was pledged as collateral with no father recourse or consequences to the borrower (other than taking their property and ruining their credit), the non-recourse statutes usually only apply to the defaulting borrower's personal residence. Since this one is an investment property now, his lender probably can -- and probably will -- sue him for their loss if they can't sell it for enough to pay all their legal expenses and all the accrued interest and late fees.
  • Even if the lender gives up and writes off the loan as a loss, that doesn’t mean he no longer owes it, it just means that they’ve decided not to waste any more time trying to collect it. Among other things, they will report their loss to the IRS, who will consider it to be taxable income for him, and will expect him to pay income taxes on as regular income. His state may do the same.

    If the lender does write it off, they may still sell the debt to a scavenger debt collector. Since the debt didn’t disappear, the original lender or their agents, or the scavenger debt collector can still sue him for the original debt plus all the accrued fees, interest, and expenses. Assuming they do so and have all their I’s dotted and t’s crossed, they can probably win a judgment against him. Then, depending on state law, they may be able to put liens on other property he owns, or may be able to seize some assets, and/or may be able to garnishee his wages.
Incidentally, if having his credit ruined, being hounded by debt collectors, and possibly having his wages garnisheed isn’t bad enough with the lenders and debt collectors, he ain’t seen nothin’ yet if he doesn’t pay the IRS the taxes he owes on any debt that was written off and reported by the original lender. The IRS has more power and less paperwork and hassle necessary to seize more of his property and assets and wages, and can often seize tax refunds or perhaps other federal money that may be payable to him.


It sounds like he is surviving and able to make the payments with the rental income. Unless he’s in such dire financial straits that he cannot afford it even with the rental income he may want to hang on.

Here's why:

A negative cash flow for a rental property does not necessarily mean that is losing money or that it is a bad investment
  • You pay money into investment accounts to save up for retirement for perhaps 30 or 40 years or more before you expect to take anything out, but I don’t see people recommending that somebody dump their 401(k)s because it’s costing them money out of pocket every year.

    It really isn’t any different for a rental property considered as an investment. What matters is whether you can afford the negative cash flow as an investment, and if the eventual net result will give you a big enough return to make it worth it to you – especially considering the extra work and risk and hassle as a landlord. – compared to investing selling the place and putting your money in mutual funds … or perhaps using it to pay down the mortgage on your personal residence.

    Assuming you have a reasonable mortgage instead of gimmicky balloon mortgage, negative amortization, or interest-only mortgage, you’re gaining net worth in the form of reduced debt – and a lot of it is being paid by the tenant.

    In normal times, and now with the real estate market recovering in many areas, you usually get appreciation in value over time too.
It's a leveraged investment because you're getting appreciation on the full value of the property, although you don’t have that much tied up in it. In fact, if you’re upside down, you don’t really have anything tied up in it because you’ve already suffered the loss. So all of the gain is profit.

Even though you’re getting that gain in your net worth, you are not paying any taxes on it, and won’t pay any taxes until you sell the home. Then when you finally do sell, you will benefit by paying only the long-term capital gains tax rate (which is usually lower than regular income taxes) on the gain.

Bear in mind that while you are getting that gain in your net worth, with a negative cash flow you are paying no taxes on it, and won’t pay any taxes until you sell the home. Then when you do sell, if there's a profit you will benefit by paying the long-term capital gains tax rate which is usually lower than regular income taxes. (The depreciation recapture may be at a higher rate.)

Meanwhile, you get great tax advantages with rental property. You take in the rental income, but you get to subtract the cost of the mortgage interest, taxes, insurance, condo or HOA fees, maintenance, repairs and other expenses, plus the phantom depreciation allowance from the rental income before you pay any income taxes on the remaining income. (The depreciation allowance lets you get an extra tax reduction even though it is not really money coming out of your pocket from year to year.) With a negative cash flow for tax calculations, no income tax.

You can even put off paying taxes on the gain in value of a property virtually forever by doing 1031 property exchanges if you need to move to another area. Once its value is enough more than you owe, you can even get some extra cash tax-free by borrowing more against the equity as your tenants pay down your mortgage balance again.

...And you can avoid the taxes on the gain in value during your lifetime forever by leaving the property to your heirs. They could sell it at its fair market value when the inherit it and not pay any tax.

HERE is another thread where folks express our varying opinions.

My posts in THIS THREAD and THIS ONE shows ways to look at the numbers to see how you may have a gain on a property even with a negative cash flow. In fact, for an upside down property with a good mortgage in an area where prices are coming back up well, the leveraged return on the investment can be very, very good.

HERE is a starting point to learn more about rental property.

And here's Publication 527 which has a lot of information.

jimb
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Re: Strategic Default

Post by technovelist »

jimb_fromATL wrote:Here are some sort-of random things he may want to think about:

First, IMO "strategic default" is just a way to pretend that defaulting on your promise to pay a debt is somehow OK if you call it something else. It doesn't relieve you of the legal (or moral) responsibility to pay people what you borrowed and promised to pay back with interest just because it's no longer convenient for you.
...
jimb
The contract between the borrower and the lender provides for what happens if the borrower doesn't repay the loan, and there are also statutory rules about such issues. So long as those terms are complied with, I'm not sure how one can assert that the borrower has breached a legal responsibility. The moral status of the borrower is another matter, but one that I would assume is outside the scope of this board.
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MilleniumBuc
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Re: Strategic Default

Post by MilleniumBuc »

It took us 2.5 years to finally be done with it through 3 different main loan servicers and 2 heloc servicers. Every 2-3 months filling all the paperwork over and over, plus every time it got sold and transferred.

Plus, whatever you negotiate with the deficiency, might or might not show up in the lAst paperwork and everyone (both realtors, closing company, etc) starts pushing you into something you don't want to do.

Have a firm grasp of what you want and don't let anyone push you into them not forgiving the lien AND the note. We bought at 240k, at the edges of a bad area, and by the time the prices started to pick up, it remained flat. Sold for 110k with 210k still owed. It wasn't completely strategic, since it was started by DW unemployment an me having to move for work and could not afford to rent + carry it, and the rentals were way less (900-1100) than piti (1600). Could not do hampa, hafsa, etc due to owing greater than 125% of current value (that later changed).

As for insolvency, you can still try that route, but they do take into account all retirement funds (401k, Ira, etc) into your net worth vs amount owed.
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JupiterJones
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Re: Strategic Default

Post by JupiterJones »

Slowmaha wrote:Moral issues aside, at what point would one consider a strategic default on a property?
Probably at the point where I could actually put the moral issues aside.
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Re: Strategic Default

Post by KyleAAA »

I think it makes sense whenever you get to the point where you can better deploy your capital after accounting for the hit to your credit, whether it's a recourse/non-recourse loan, etc. In other words, when it's a slam dunk. I probably wouldn't risk it if it would take, say, 15 years to reasonably reach a break-even point. But if you can walk away and can be reasonably sure you won't need to borrow again for another 7 years, I say go for it.

There's no moral component whatsoever to a default, IMO. You took a risk and the bank did too. Usually the bank wins, but sometimes it doesn't. That's how risk works. You certainly have no moral obligation to the bank beyond what's in the contract you signed because you never promised anything more.
an_asker
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Re: Strategic Default

Post by an_asker »

jimb_fromATL wrote:Here are some sort-of random things he may want to think about:

First, IMO "strategic default" is just a way to pretend that defaulting on your promise to pay a debt is somehow OK if you call it something else. It doesn't relieve you of the legal (or moral) responsibility to pay people what you borrowed and promised to pay back with interest just because it's no longer convenient for you.

He also needs to realize that his credit rating will be ruined for a minimum of 7 years, and the default will always be a public record that can haunt him if he ever needs to borrow money for anything else in the future.
  • A short sale is not something he gets to choose, by the way. It's the lender's choice, and they're not likely to consider it until he has defaulted on the loan for a long time. Then, if they feel that he does not have enough income or assets worth pursuing, they may choose a short sale to make it a little easier to get their property back ... with lower legal costs. If he has income and assets, they're much less likely to be interested in letting him walk away easy while they and their investors and shareholders take the loss.

    By the way, a short sale is still roughly equivalent to a foreclosure or deed-in-lieu of foreclosure, and will adversely affect his credit rating by about the same amount as a foreclosure.
Next, while some states are "non-recourse" for mortgages, in that the lender can only take back the property that was pledged as collateral with no father recourse or consequences to the borrower (other than taking their property and ruining their credit), the non-recourse statutes usually only apply to the defaulting borrower's personal residence. Since this one is an investment property now, his lender probably can -- and probably will -- sue him for their loss if they can't sell it for enough to pay all their legal expenses and all the accrued interest and late fees.
  • Even if the lender gives up and writes off the loan as a loss, that doesn’t mean he no longer owes it, it just means that they’ve decided not to waste any more time trying to collect it. Among other things, they will report their loss to the IRS, who will consider it to be taxable income for him, and will expect him to pay income taxes on as regular income. His state may do the same.

    If the lender does write it off, they may still sell the debt to a scavenger debt collector. Since the debt didn’t disappear, the original lender or their agents, or the scavenger debt collector can still sue him for the original debt plus all the accrued fees, interest, and expenses. Assuming they do so and have all their I’s dotted and t’s crossed, they can probably win a judgment against him. Then, depending on state law, they may be able to put liens on other property he owns, or may be able to seize some assets, and/or may be able to garnishee his wages.
Incidentally, if having his credit ruined, being hounded by debt collectors, and possibly having his wages garnisheed isn’t bad enough with the lenders and debt collectors, he ain’t seen nothin’ yet if he doesn’t pay the IRS the taxes he owes on any debt that was written off and reported by the original lender. The IRS has more power and less paperwork and hassle necessary to seize more of his property and assets and wages, and can often seize tax refunds or perhaps other federal money that may be payable to him.
[...]
jimb
Broadly speaking, I happen to agree with you that folks should not be strategically defaulting.

That said, I don't think you (or I) should be bullying them into not doing so. It is for them to see what is best for their family - your response would've been appropriate had OP asked a question whether or not the default should happen. We are past that point now; thousands of folks have strategically defaulted and are now much ahead of other folks in similar situations (but who did not strategically default).

So, what you are doing is using scaremongering to try to get OP's brother to not strategically default. Besides, some things that you're scaring him/her of won't even be that scary. I know folks who have strategically defaulted a couple of years ago and have already bought houses since then at a sub-3.5 fixed interest rate. In other words, it can be done and does not need seven years like you appear to be implying.
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Re: Strategic Default

Post by an_asker »

KyleAAA wrote:[...]But if you can walk away and can be reasonably sure you won't need to borrow again for another 7 years, I say go for it.
[...]
Like I responded to jimb_fromATL, that 7 years is a gross exaggeration. Urban Legend maybe? I have friends who have re-bought within a couple of years of strategically defaulting ... and with a fixed-term loan that had a sub 3.5% interest rate.
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Re: Strategic Default

Post by Easy Rhino »

it will remain on your credit report for 7 years, how about that?

The recency of the default will affect different lenders in different ways for different lengths of time.

For instance FHA had a hard 3 year moratorium after default:
http://www.zillow.com/advice-thread/wha ... le/487827/
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jimb_fromATL
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Re: Strategic Default

Post by jimb_fromATL »

an_asker wrote:
KyleAAA wrote:[...]But if you can walk away and can be reasonably sure you won't need to borrow again for another 7 years, I say go for it.
[...]
Like I responded to jimb_fromATL, that 7 years is a gross exaggeration. Urban Legend maybe? I have friends who have re-bought within a couple of years of strategically defaulting ... and with a fixed-term loan that had a sub 3.5% interest rate.
True, it is a personal decision whether moral considerations are of any importance to any individual when it comes to reneging on a debt. But calling it something else doesn't change the fact that you didn't pay back what you borrowed --with interest-- as you promised.

Aside from that, I was pointing out that regardless of any moral considerations, you don't just walk away from a mortgage without any consequences at all.

Also --very important IMO-- is to understand that a negative cash flow and/or an upside down mortgage does not mean that the property is a bad investment that justifies reneging on the debt and suffering the conseqences it may cause.
  • You might not choose that property as a new investment (and are not likely to be able to finance it with a negative down payment anyway). But to repeat, for someone who became an "accidental landlord" because of the crash of the real estate market, an upside down rental property with a good mortgage and which is recovering in value can give an unusually high leveraged rate of return, even with a negative cash flow -- if you can afford the n expenditure as an investment while you ride it out.

The seven years of detrimental information on a credit report (10 years for bankruptcy) is not an urban legend, although some people may be able to get new mortgages a lot sooner than that ... especially in this recovering economy when money is readily available and perhaps artificially cheap.
  • Last time I checked FHA loans were available within about two or three years. Interest rates are still very, low compared to previous decades, but the up-front MIP and monthly premium are a lot higher and for a lot longer because so many people have defaulted. That makes those loans a lot more expensive than they would have been with similar rates before the crash. There are more stringent requirements for true and fair market appraisals and for qualifying for loans, too; and second mortgages and gimmicks for loaning a lot more than the property is worth are no long available.
Even when negative reports and records of judgments and liens, bankruptcies, etc disappear from your credit report, the private records kept by lenders, and the public records of past financial and legal matters such as deeds, mortgages, judgments and liens still exist -- and can still bite you on the behind at some time in the future, depending on the circumstances.

In addition to qualifying for some kinds of loans, among other things negative information about judgments, etc that will show up in a thorough background check can affect one's ability to be considered for some job applications, security clearances, and job responsibilities, assignments, or promotions. So there's a lot more to consider than just whether to walk out on the mortgage if the property is not making a lot of money from month ot month.

jimb
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Re: Strategic Default

Post by Twins Fan »

Slowmaha wrote:Moral issues aside, at what point would one consider a strategic default on a property?

Situation:

My brother purchased a condo at the top of the bubble, later got married, got out of the military, and moved out of state. The condo is STILL 25-30k under water 8 years later. He currently has a renter that covers the mortgage interest, but that's about it. The proverbial straw may have come last week when the condo HOA hit him with a $4,500 special assessment due in Nov.

He has paid faithfully for 8 years but is considering doing a strategic default to unleash this albatross. His credit otherwise is excellent.

Has anyone had to make this decision? I'd be curious to hear your take.
From the situation given, that point would have been about 8 years ago. :D

I agree with much of what jimb has said, so I will leave that as it is. I also became an accidental landlord just over 4 years ago. I looked into all the things mentioned in this thread, my rental is also in a recourse state (that's kinda scary :shock: ), and after all things considered I chose to ride it out. Things have improved for me there and the situation is much more comfortable now.

I would lean towards, your brother is too far into this to walk away. Sure, he could walk away and consider the past 8 years a sunk cost. But at this point, why not ride it out and wait for things to improve? What's the $4500 assessment for... something to improve the complex? Could he raise the rent after that... would the value of his condo go up? Why hasn't he walked away at any point in the past 8 years?
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Re: Strategic Default

Post by Jozxyqk »

jimb_fromATL wrote:
First, IMO "strategic default" [. . .] doesn't relieve you of the legal (or moral) responsibility to pay people what you borrowed and promised to pay back with interest just because it's no longer convenient for you.
This is just wrong. At least in non-recourse states (and for a variety of legal reasons in many other states as well), strategic default in fact specifically relieves you of the legal responsibility to pay back what you borrowed.
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Re: Strategic Default

Post by placeholder »

I guarantee the bank isn't worried about morality in its dealings with you.
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Re: Strategic Default

Post by Jack »

State law will determine if this is a recourse or non-recourse loan. If it is non-recourse, then there is no tax for debt forgiveness because there is no debt to forgive. If non-recourse, the bank's only option is to foreclose on the property. There is no forgiveness of debt. The bank writes it off as a bad debt and takes a tax deduction.
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Re: Strategic Default

Post by jimb_fromATL »

Jozxyqk wrote:
jimb_fromATL wrote:
First, IMO "strategic default" [. . .] doesn't relieve you of the legal (or moral) responsibility to pay people what you borrowed and promised to pay back with interest just because it's no longer convenient for you.
This is just wrong. At least in non-recourse states (and for a variety of legal reasons in many other states as well), strategic default in fact specifically relieves you of the legal responsibility to pay back what you borrowed.
I agree that I didn't make it clear that I was thinking in terms of the rental property, and agree that in a non-recourse state the lender cannot seek recourse other than taking the house IF it is the borrower's primary residence. Here's One of a zillion articles on the subject.

But I don't know of any states where non-recourse applies to rental property or other loans for investments. Seems to me that if people could borrow money to invest and then just walk away any time their investment didn't make money, the entire system would soon collapse. It's already well known that borrowers are a lot more likely to default on mortgage loans when it's not on their home where they live and where their stuff is. So it would no doubt be a lot worse if there were no consequences at all for walking away from any rental property that wasn't profitable enough soon enough.

Moral responsibility is a different animal, but that's not the issue here. The important points are that the OP's brother cannot just walk away from the debt on his rental property without some consequences. And it may not be losing as much as he thinks -- if any.

To expand on it, the default is still reported on your credit report and in public records for either a residence or rental. As far as I know the tax exemption for the amount written off only applies for the borrower's personal residence, too.

So --assuming he has any signficant income-- in addition to the bad credit report, the brother would most likely be hit with a sizeable tax bill if he decides to walk. I'm not clear on how he would be taxed for the depreciation recapture, but it's something else he'd need to look into. If he does have significant income and assets, it's also more likely that he'll be sued for the lender's loss.

More on the plus side:

SInce he's several years into the mortgage, he's getting more equity/net worth in the form of reduced debt than he was a few years ago, and it's getting better every year.

Unless the condo complex has really gone downhill, chances are it is increasing in value too.

The new assessment is an additional deduction if it's an expense, or an adjustment to his cost basis if it's a capital improvement, so he gets a tax break for it either now or later. Either way, it probably increases the value of the property, which improves his net worth but with taxes still deferred on it.

jimb
denovo
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Re: Strategic Default

Post by denovo »

Jozxyqk wrote:
jimb_fromATL wrote:
First, IMO "strategic default" [. . .] doesn't relieve you of the legal (or moral) responsibility to pay people what you borrowed and promised to pay back with interest just because it's no longer convenient for you.
This is just wrong. At least in non-recourse states (and for a variety of legal reasons in many other states as well), strategic default in fact specifically relieves you of the legal responsibility to pay back what you borrowed.
I wanted to reitirate this. The Op specifically asked people to keep their morality opinions to themselves but some people couldn't help themselves.
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denovo
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Re: Strategic Default

Post by denovo »

jimb_fromATL wrote:Here are some sort-of random things he may want to think about:

First, IMO "strategic default" is just a way to pretend that defaulting on your promise to pay a debt is somehow OK if you call it something else. It doesn't relieve you of the legal (or moral) responsibility to pay people what you borrowed and promised to pay back with interest just because it's no longer convenient for you.

He also needs to realize that his credit rating will be ruined for a minimum of 7 years, and the default will always be a public record that can haunt him if he ever needs to borrow money for anything else in the future.
  • A short sale is not something he gets to choose, by the way. It's the lender's choice, and they're not likely to consider it until he has defaulted on the loan for a long time. Then, if they feel that he does not have enough income or assets worth pursuing, they may choose a short sale to make it a little easier to get their property back ... with lower legal costs. If he has income and assets, they're much less likely to be interested in letting him walk away easy while they and their investors and shareholders take the loss.

    By the way, a short sale is still roughly equivalent to a foreclosure or deed-in-lieu of foreclosure, and will adversely affect his credit rating by about the same amount as a foreclosure.
Next, while some states are "non-recourse" for mortgages, in that the lender can only take back the property that was pledged as collateral with no father recourse or consequences to the borrower (other than taking their property and ruining their credit), the non-recourse statutes usually only apply to the defaulting borrower's personal residence. Since this one is an investment property now, his lender probably can -- and probably will -- sue him for their loss if they can't sell it for enough to pay all their legal expenses and all the accrued interest and late fees.
  • Even if the lender gives up and writes off the loan as a loss, that doesn’t mean he no longer owes it, it just means that they’ve decided not to waste any more time trying to collect it. Among other things, they will report their loss to the IRS, who will consider it to be taxable income for him, and will expect him to pay income taxes on as regular income. His state may do the same.

    If the lender does write it off, they may still sell the debt to a scavenger debt collector. Since the debt didn’t disappear, the original lender or their agents, or the scavenger debt collector can still sue him for the original debt plus all the accrued fees, interest, and expenses. Assuming they do so and have all their I’s dotted and t’s crossed, they can probably win a judgment against him. Then, depending on state law, they may be able to put liens on other property he owns, or may be able to seize some assets, and/or may be able to garnishee his wages.
Incidentally, if having his credit ruined, being hounded by debt collectors, and possibly having his wages garnisheed isn’t bad enough with the lenders and debt collectors, he ain’t seen nothin’ yet if he doesn’t pay the IRS the taxes he owes on any debt that was written off and reported by the original lender. The IRS has more power and less paperwork and hassle necessary to seize more of his property and assets and wages, and can often seize tax refunds or perhaps other federal money that may be payable to him.


It sounds like he is surviving and able to make the payments with the rental income. Unless he’s in such dire financial straits that he cannot afford it even with the rental income he may want to hang on.

Here's why:

A negative cash flow for a rental property does not necessarily mean that is losing money or that it is a bad investment
  • You pay money into investment accounts to save up for retirement for perhaps 30 or 40 years or more before you expect to take anything out, but I don’t see people recommending that somebody dump their 401(k)s because it’s costing them money out of pocket every year.

    It really isn’t any different for a rental property considered as an investment. What matters is whether you can afford the negative cash flow as an investment, and if the eventual net result will give you a big enough return to make it worth it to you – especially considering the extra work and risk and hassle as a landlord. – compared to investing selling the place and putting your money in mutual funds … or perhaps using it to pay down the mortgage on your personal residence.

    Assuming you have a reasonable mortgage instead of gimmicky balloon mortgage, negative amortization, or interest-only mortgage, you’re gaining net worth in the form of reduced debt – and a lot of it is being paid by the tenant.

    In normal times, and now with the real estate market recovering in many areas, you usually get appreciation in value over time too.
It's a leveraged investment because you're getting appreciation on the full value of the property, although you don’t have that much tied up in it. In fact, if you’re upside down, you don’t really have anything tied up in it because you’ve already suffered the loss. So all of the gain is profit.

Even though you’re getting that gain in your net worth, you are not paying any taxes on it, and won’t pay any taxes until you sell the home. Then when you finally do sell, you will benefit by paying only the long-term capital gains tax rate (which is usually lower than regular income taxes) on the gain.

Bear in mind that while you are getting that gain in your net worth, with a negative cash flow you are paying no taxes on it, and won’t pay any taxes until you sell the home. Then when you do sell, if there's a profit you will benefit by paying the long-term capital gains tax rate which is usually lower than regular income taxes. (The depreciation recapture may be at a higher rate.)

Meanwhile, you get great tax advantages with rental property. You take in the rental income, but you get to subtract the cost of the mortgage interest, taxes, insurance, condo or HOA fees, maintenance, repairs and other expenses, plus the phantom depreciation allowance from the rental income before you pay any income taxes on the remaining income. (The depreciation allowance lets you get an extra tax reduction even though it is not really money coming out of your pocket from year to year.) With a negative cash flow for tax calculations, no income tax.

You can even put off paying taxes on the gain in value of a property virtually forever by doing 1031 property exchanges if you need to move to another area. Once its value is enough more than you owe, you can even get some extra cash tax-free by borrowing more against the equity as your tenants pay down your mortgage balance again.

...And you can avoid the taxes on the gain in value during your lifetime forever by leaving the property to your heirs. They could sell it at its fair market value when the inherit it and not pay any tax.

HERE is another thread where folks express our varying opinions.

My posts in THIS THREAD and THIS ONE shows ways to look at the numbers to see how you may have a gain on a property even with a negative cash flow. In fact, for an upside down property with a good mortgage in an area where prices are coming back up well, the leveraged return on the investment can be very, very good.

HERE is a starting point to learn more about rental property.

And here's Publication 527 which has a lot of information.

jimb
There is a lot of information here that is incorrect that I feel compelled to correct.I am on a smartphone so I apologize in advance for any spelling or formatting errors.

1. Contrary to what is implied above default does relieve one of legal responsibility in a nonrecourse state. Moreover even in a recourse that it is rare for mortgage lenders to go after borrowers because they know that they are usually not in great financial straits and it is difficult to collect. likewise it is flat out wrong imply that he is not eligible because he now uses as an investment property what matters is how the property was purchased and it was purchased as a primary residence end of discussion!

2. a lot of gross exaggeration about the effect on credit. Negative information is wiped out in seven year and it does not ruin your credit for 7 years. The negative impact is diluted every single year and by the last two to three years it may not even have any impact on your credit score.
3. in regards to the tax liability the poster conveniently ignores the fact that you will be exempt from any income taxation if you can prove insolency.

a lot of the so-called benefits of real estate investing that Jim has mentioned is illusory.
4. the comparison to 401 K's is not correcteven though you may not draw from the 401 K for 30 to 40 years it doesn't mean it doesn't have a positive value.
5. when considering real estate appreciation it has historically been less than equity returns so who cares if the real estate goes up over time.
6. it should not be considered a benefit that landlords can deduct mortgage interest taxes or homeowner association fees all businesses are able to deduct expenses. would anyone considered to be a great tax benefit that businesses are able to deduct the wages or equipment cost????
7. the stepped up basis for real estate also applies to other assets including stocks so it's not really just a benefit for Real estate and you can also deduct losses from any business that loses money would anyone be happy after losing money so they can do some of that from their tax?????
8. depreciation is a real loss and then there is a reason that every business make an account of it in their books. building degrade overtime and for whatever reason you're able to sell for more than the depreciation lost the IRS will recapture.

When people indicate they have a moral problem with what you want to do I would be skeptical of the rest of the advice
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Re: Strategic Default

Post by Twins Fan »

[OT comment removed by admin LadyGeek]
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Re: Strategic Default

Post by JamesSFO »

Slowmaha wrote:Moral issues aside, at what point would one consider a strategic default on a property?

Situation:

My brother purchased a condo at the top of the bubble, later got married, got out of the military, and moved out of state. The condo is STILL 25-30k under water 8 years later. He currently has a renter that covers the mortgage interest, but that's about it. The proverbial straw may have come last week when the condo HOA hit him with a $4,500 special assessment due in Nov.

He has paid faithfully for 8 years but is considering doing a strategic default to unleash this albatross. His credit otherwise is excellent.

Has anyone had to make this decision? I'd be curious to hear your take.
Can you provide a bit more information, $25-30K is the gap of "underwater" but:

1) what's the remaining mortgage balance?

2A) Are you in a non-recourse state?

2B) Is the current loan the original purchase loan (e.g. CA is non-recourse, but only for the original purchase loan)?

3) When you say renters pay the mortgage interest, do you literally mean only the interest or do you mean they cover the monthly payment?

4) Does your brother want to go back into the military or does your brother need to join a profession/change jobs to something that requires a background check where a default could trigger high scrutiny?

Best!
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Re: Strategic Default

Post by tainted-meat »

As others have mentioned, check to see if it is a non-recourse state.

The implications of defaulting on one's career can be enormous, but some employers may understand.

Good luck to your brother, that is a tough situation to be in and one many people found themselves in.
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Re: Strategic Default

Post by Kenkat »

The only thing about the moral issue is that businesses and wealthy people don't usually have moral issues with these questions. It's a deal gone south and you operate under the laws as written. Others may disagree and I understand that too.

I think the real question is - is the credit hit your brother will take worth saving $25k? I would say it is not. If we were talking $250k, then my answer would be different.
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Re: Strategic Default

Post by richard »

kenschmidt wrote:The only thing about the moral issue is that businesses and wealthy people don't usually have moral issues with these questions. It's a deal gone south and you operate under the laws as written. Others may disagree and I understand that too.
It's much easier to have moral issues with things that hurt businesses if you have equity interests in many businesses (e.g., stock funds) and don't have debt or otherwise have a financial interest in others not defaulting. Lending banks don't have problems with morality or even the law, based on the amounts they are paying to settle mortgage fraud issues.
kenschmidt wrote:I think the real question is - is the credit hit your brother will take worth saving $25k? I would say it is not. If we were talking $250k, then my answer would be different.
Is it even $25k? If a renter is covering mortgage payments, the cash hit from the situation situation seems relatively small.

OP - what costs are there other than the HOA assessment?
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Re: Strategic Default

Post by Jozxyqk »

jimb_fromATL wrote:
Jozxyqk wrote:
jimb_fromATL wrote:
First, IMO "strategic default" [. . .] doesn't relieve you of the legal (or moral) responsibility to pay people what you borrowed and promised to pay back with interest just because it's no longer convenient for you.
This is just wrong. At least in non-recourse states (and for a variety of legal reasons in many other states as well), strategic default in fact specifically relieves you of the legal responsibility to pay back what you borrowed.
I agree that I didn't make it clear that I was thinking in terms of the rental property, and agree that in a non-recourse state the lender cannot seek recourse other than taking the house IF it is the borrower's primary residence. Here's One of a zillion articles on the subject.
Again, this is wrong. I practice law in Washington State. In Washington, if the loan was *made* for non-commercial purposes (e.g., residence, vacation home, mother-in-law's house), the lender has no legal ability to seek a deficiency judgment when they complete a non-judicial foreclosure (which a lender facing a $25k deficiency would almost certainly do). It doesn't matter if the property is currently the borrower's primary residence or if the borrower is renting the property, or if the borrower ever lived there at all. I obviously haven't done a 50-state survey on this topic, so I can't speak to other states, but I refrain from expounding on subjects where I don't actually know the answer.

OP -- as other posters have said, your brother needs to find out what the law is in his state and proceed from there. It may be the determining factor to whether this is a good idea or not.
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Re: Strategic Default

Post by jghassell »

Can anyone speak to how the $4,500 special assessment could be avoided? It seems unlikely a foreclosure would occur before November, and to the extent of my knowledge--which is limited--the HOA might well decide to go after the owner legally if that remains unpaid, regardless of how the condo is disposed.
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Re: Strategic Default

Post by Slowmaha »

Thanks for the lively debate. I'll throw out a little more information:

1. My understanding is the state in question very much IS a recourse state, so that may be the deciding factor.. Does it matter if he no longer lives in that state?

2. He has good income and is not insolvent in any way

3. I don't know what the renter covers but it is not the entire PITI.. Sounds like the rent covers maybe the ITI but not the P or the monthly HOA fees

4. The assessment is for an expensive maintenance project. It will not likely drive complex appreciation, perhaps just keep it from DEPRECIATING. Sounds like a poorly run HOA to me, I suggested he double check to ensure they have been performing their required fiduciary responsibilities.

Hope that helps. Thanks again for the inputs.
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Re: Strategic Default

Post by sscritic »

In states such as California, HOA dues or assessments are considered personal debts of the homeowner associated with them. Your HOA might lose its lien on your home because of your foreclosure but you might still owe a personal debt to the HOA. It's not unusual for homeowners associations to file lawsuits against delinquent current and former owners to collect what they're owed. In California, HOAs owed money by their former or current members can even obtain court-ordered money judgments against them.
The assessment has already been made, but the payment is not due until November. That the payment is not due until November does not mean the debt does not exist.
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Re: Strategic Default

Post by N1CKV »

placeholder wrote:I guarantee the bank isn't worried about morality in its dealings with you.
...and I bet you would be the first person to sue the snot out of the bank if they were the one's trying to change the contract terms mid-stroke in their favor?

FWIW: I wouldn't consider a strategic default unless the payments were impossible to maintain. A mortgage is a contract for a promise to pay. When you give your word that you will do something, you do it unless it's just not possible for unforeseen reasons. That's just my opinion, but it seems the way I was raised to respect a person's word isn't consistent with what other folks were taught.
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Re: Strategic Default

Post by Twins Fan »

Slowmaha wrote:1. My understanding is the state in question very much IS a recourse state, so that may be the deciding factor.. Does it matter if he no longer lives in that state?
From what I understood looking into all this, nope doesn't matter where he lives. It would go off where the property is.

That's another thing to think about... I believe the HOA could go after him if he walks away from this. And, while the mortgage company may or may not, you can be almost certain the HOA.....

I'm also an out of state landlord. Does your brother use a property management company, or run this all himself? When is the last time he raised the rent? Being out of state, I use a property management company. They take 10% of the rent each month and other fees when new tenants/advertising/etc. are needed, but it's well worth it to me for my situation.
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Re: Strategic Default

Post by killjoy2012 »

kenschmidt wrote:I think the real question is - is the credit hit your brother will take worth saving $25k? I would say it is not. If we were talking $250k, then my answer would be different.
+1. Why would someone who is young and making 6 figures put their credit history and potentially their next 30 years of employability on the line for a measly $25k, especially when that $25k is a paper number (not realized) and offset, at least somewhat, by the rental income? If we were talking about being underwater $200k+, or if the person was low income, OK - then yes, maybe that may be a good idea. But given what I read in the OP, it just doesn't seem to make a lot of sense.

My car is $25k underwater too - I bought it for $30k 8 years ago and it's only worth $5k now. Do I walk away from it (repo'd)? I think the OP needs to put the magnitude of $25k in perspective, aside from any moral issues.
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Re: Strategic Default

Post by an_asker »

killjoy2012 wrote:[...]My car is $25k underwater too - I bought it for $30k 8 years ago and it's only worth $5k now. Do I walk away from it (repo'd)? I think the OP needs to put the magnitude of $25k in perspective, aside from any moral issues.
That is not how underwater is defined. Unless you have not paid a penny for your car over the last eight years.
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Re: Strategic Default

Post by Twins Fan »

It was simply a point being made.

I really hope picking apart posts makes some of you feel better. :wink:
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Re: Strategic Default

Post by Slowmaha »

Twins Fan wrote:
Slowmaha wrote:1. My understanding is the state in question very much IS a recourse state, so that may be the deciding factor.. Does it matter if he no longer lives in that state?
From what I understood looking into all this, nope doesn't matter where he lives. It would go off where the property is.

That's another thing to think about... I believe the HOA could go after him if he walks away from this. And, while the mortgage company may or may not, you can be almost certain the HOA.....

I'm also an out of state landlord. Does your brother use a property management company, or run this all himself? When is the last time he raised the rent? Being out of state, I use a property management company. They take 10% of the rent each month and other fees when new tenants/advertising/etc. are needed, but it's well worth it to me for my situation.

He does use a property manager to the tune of 10%, I believe.. I think he's at the upper end of the rent range so raising rents at this time probably isn't likely.

Thanks for posting.
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Re: Strategic Default

Post by Jozxyqk »

N1CKV wrote:
placeholder wrote:I guarantee the bank isn't worried about morality in its dealings with you.
...and I bet you would be the first person to sue the snot out of the bank if they were the one's trying to change the contract terms mid-stroke in their favor?

FWIW: I wouldn't consider a strategic default unless the payments were impossible to maintain. A mortgage is a contract for a promise to pay. When you give your word that you will do something, you do it unless it's just not possible for unforeseen reasons. That's just my opinion, but it seems the way I was raised to respect a person's word isn't consistent with what other folks were taught.
Strategic default on a non-recourse mortgage (while OT here apparently) is not changing the contract terms mid-stroke. In a non-recourse mortgage, the bank agreed with eyes open to take the property in lieu of the debt if you defaulted. It is perfectly legal and the bank knowingly entered into the contract with the expectation that that eventuality could occur.

The bank is concerned about the bottom line. They won't do things that give a customer the option to "sue the snot" out of them because that's a money loser. But if a bank has the option to legally eliminate a potentially crippling monetary obligation (even one it contractually agreed to pay) at a lower cost than actually paying the obligation? You'd better believe it will do that in a heartbeat. Morgan Stanley failed to pay back billions of dollars in loans on commercial buildings in San Francisco (explaining, apparently without irony, that “This isn’t a default or foreclosure situation. We are going to give them the properties to get out of the loan obligation.”) http://www.bloomberg.com/apps/news?pid= ... XOSk&pos=5 Well of course! Giving back property to get out of a loan obligation -- completely different from what residential property owners want to do! Real estate companies do the same thing. http://online.wsj.com/news/articles/SB1 ... TWhatsNews

It's super bizarre consumers have somehow become convinced that banks and large companies are entitled to make "business decisions" like this, but consumers are morally bankrupt if they make a similar business decision and should "keep their word" unless they have absolutely no other option.

OP -- it sounds like your brother is on the hook for HOA fees one way or another, and probably on the hook for the $25k deficiency one way or another. Strategic default is risky at best. I'd think about either hanging on to the property or actually trying to negotiate something with the lender to pay off the loan and get out (short sale, deed in lieu). A meeting with a good lawyer might be worth a couple of hundred bucks.

Twins Fan -- picking apart posts is helpful when it illustrates why the advice they give is bad or suspect. Killjoy's example didn't make sense unless he actually still owes $30k on his car.
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Re: Strategic Default [on a property]

Post by LadyGeek »

With regards to posts made earlier in the thread, the points on the moral aspects have been made. Let's try to stay factual.

I also retitled the thread for clarity.
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Re: Strategic Default

Post by placeholder »

N1CKV wrote:
placeholder wrote:I guarantee the bank isn't worried about morality in its dealings with you.
...and I bet you would be the first person to sue the snot out of the bank if they were the one's trying to change the contract terms mid-stroke in their favor?
If the bank were doing something illegal certainly.
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Re: Strategic Default [on a property]

Post by Quickfoot »

If he is still underwater and is considering letting it go he should look at a short sale instead of a foreclosure, Died in Lieu of foreclosure is also an option sometimes. In any case don't stop making the payments, that is what hurts your credit the most. Short sale hurts your credit a lot less than a foreclosure, mostly because usually with foreclosure you stop making payments so you get also 90-120+ day delinquency.
The condo is STILL 25-30k under water 8 years later
Is this assessed value or appraised value? They are drastically different, property almost always sells for more than it is assessed at. Before he chooses to do anything if he hasn't yet he should pay for an appraisal. He should also take a look at rentometer to see if he is able to raise rent or refinance to a lower interest rate or lower the payment by stretching the term out and turn the property into a cashflowing rental.
He also needs to realize that his credit rating will be ruined for a minimum of 7 years, and the default will always be a public record that can haunt him if he ever needs to borrow money for anything else in the future.
VASTLY overstated, with a short sale if he has otherwise good to great credit and doesn't stop paying other bills he'll probably see about a 100 point drop in credit score, 150 for a foreclosure. His credit will take a drop for a while but it will not be ruined, within 2 years he should be able to get credit cards and at 3 years qualify for a mortgage (2 for short sale).

I had a foreclosure 3 years ago, wife had a short sale 2 years ago (both as results of previous divorces). We both had > 830 credit scores, mine is at 700 and hers is at 730. In the last 2 years we've leased two new > 30K vehicles and we get "high" credit score credit card offers all the time.

The biggest impact for us has been waiting to qualify for a mortgage again and the psychological stress of having a lower credit score.
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Re: Strategic Default [on a property]

Post by ResearchMed »

IF he decides to pursue this type of strategic default, once he has made up his mind, he should probably consult an attorney.

The TENANT may have rights. What is the term of the lease (or is it monthly)?
In some states, tenants have very strong rights; in others, not nearly so much.

Several "next steps" include stopping mortgage payments, while the process meanders along.
That money would just go down a bottomless pit.

Also consider the Deed in Lieu (of foreclosure).
He might be able to get the lender to PAY HIM to do this, as this avoids the problem of foreclosure, and lets the lender "get on with it" faster, meaning re-sell it, rather than dragging it out for months (or years) and only then have a chance to get any money at all out of it.

And the lender MIGHT even PAY HIM to handle this as a Deed in Lieu, calling it "moving expenses" or such.
(Ask an attorney. I am NOT one. HOW any such payment is handled could affect the tax treatment.)

The tenant situation could affect this greatly, if it would interfere with the lender moving forward with more ease.

How much is the shortfall each month?

What is happening to property values nearby? Rising slowly? Stagnant? Dropping??
If the first, then perhaps just holding it for a while, and then selling when it's closer to even is something to consider.

RM
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Re: Strategic Default [on a property]

Post by Watty »

The condo is STILL 25-30k under water 8 years later. He currently has a renter that covers the mortgage interest, but that's about it. The proverbial straw may have come last week when the condo HOA hit him with a $4,500 special assessment due in Nov.

A short sale that the bank agrees to is one thing but walking away and defaulting is something else. He needs to look at all the costs of defaulting;

1) His lawyer fees, to do it right.
2) It will likely drag on for a long time until the foreclosure is complete. During that time HOA fees and property taxes would still likely be adding up and he would likely not be able to get out of those without declaring bankruptcy. Some lenders are not quick to foreclose so he could get stuck with a year or more of these costs.
3) Possible taxes on the defaulted amount. The laws have gone back back and forth but at one time they were taxable. If he has been taking depreciation on the property then that may be taxed when he gets out of the house.
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Re: Strategic Default [on a property]

Post by Slowmaha »

ResearchMed wrote:IF he decides to pursue this type of strategic default, once he has made up his mind, he should probably consult an attorney.

The TENANT may have rights. What is the term of the lease (or is it monthly)?
In some states, tenants have very strong rights; in others, not nearly so much.

Several "next steps" include stopping mortgage payments, while the process meanders along.
That money would just go down a bottomless pit.

Also consider the Deed in Lieu (of foreclosure).
He might be able to get the lender to PAY HIM to do this, as this avoids the problem of foreclosure, and lets the lender "get on with it" faster, meaning re-sell it, rather than dragging it out for months (or years) and only then have a chance to get any money at all out of it.

And the lender MIGHT even PAY HIM to handle this as a Deed in Lieu, calling it "moving expenses" or such.
(Ask an attorney. I am NOT one. HOW any such payment is handled could affect the tax treatment.)

The tenant situation could affect this greatly, if it would interfere with the lender moving forward with more ease.

How much is the shortfall each month?

What is happening to property values nearby? Rising slowly? Stagnant? Dropping??
If the first, then perhaps just holding it for a while, and then selling when it's closer to even is something to consider.

RM

Shortfall is about $600 a month not including principal. Insurance, hoa fees, property management fees

Looks like the market is pretty stagnant to me.
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Re: Strategic Default

Post by TRC »

technovelist wrote:
jimb_fromATL wrote:Here are some sort-of random things he may want to think about:

First, IMO "strategic default" is just a way to pretend that defaulting on your promise to pay a debt is somehow OK if you call it something else. It doesn't relieve you of the legal (or moral) responsibility to pay people what you borrowed and promised to pay back with interest just because it's no longer convenient for you.
...
jimb
The contract between the borrower and the lender provides for what happens if the borrower doesn't repay the loan, and there are also statutory rules about such issues. So long as those terms are complied with, I'm not sure how one can assert that the borrower has breached a legal responsibility. The moral status of the borrower is another matter, but one that I would assume is outside the scope of this board.
+1.
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Re: Strategic Default [on a property]

Post by ralph124cf »

Several people have mentioned income taxes on the "forgiven" debt. However, this is a business (rental property).

Assuming that he started his rental business (voluntary or not) declaring that his basis was whatever he had paid for the condo (which would not necessarily be correct, but if the IRS has been accepting it for eight years, then they are unlikely to challenge it now), then he will probably have a loss on the sale of this business asset. This loss will likely wipe out any gain from the debt forgiveness. Also, if his AGI was above $150,000, the ongoing losses would not have been deductible currently, but would have been accumulating and suspended until the property was disposed of.

Ralph
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Re: Strategic Default [on a property]

Post by jimb_fromATL »

ralph124cf wrote:Several people have mentioned income taxes on the "forgiven" debt. However, this is a business (rental property).

Assuming that he started his rental business (voluntary or not) declaring that his basis was whatever he had paid for the condo (which would not necessarily be correct, but if the IRS has been accepting it for eight years, then they are unlikely to challenge it now)...

He hasn't sold it or defaulted, so the cost basis he might use for claiming any loss has not come up to the IRS to accept yet.
..., then he will probably have a loss on the sale of this business asset...
It's not absolutely clear in the OP, but it appears that he's an "accidental landlord" who chose to convert the home to a rental rather than sell it at a loss because it had already dropped in value by the time he needed to move. Logic also supports that supposition, since if it had not already lost a lot of value by the time he no longer needed it, he would have sold it instead of keeping it with a big negative cash flow. Real estate values in most areas have been recovering, so chances are good it's worth more now than when he put it into rental service.
This loss will likely wipe out any gain from the debt forgiveness. Also, if his AGI was above $150,000

Whether he gets to avoid taxes on the loss or not, much like the reason that Robin Hood robbed from the rich instead of the poor * and tax brackets are higher for richer people, If his AGI has been and still is over $150K, all the more likely it would be worth the lender's effort to sue him for the deficit ... because he has money and assets.

MORE about basis and loss.

jimb



* Because the poor didn't have any money.
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