Strategic Default and Rentals

[Patrick McNeill]

I have a friend (we'll call him Joe) who is considering doing a strategic default on his home.

Although it's a struggle, he makes enough to pay his mortgage. But his house has gone down considerably in value and he owes much more than it is worth.

Joe owns four rental properties also. Two are paid off and two have mortgages. They are all rented out and cash flow.

The rentals were all purchased in his name but have since been changed in the county records to an LLC.

My question is, if Joe does a strategic default and stops paying just his home's mortgage, what can happen with his rental properties?
Is there any recourse the bank can take?
He would not be claiming bankruptcy, just staying in his current home until they kick him out.

[Jon Holdman]

Here in CO foreclosures are handled by the "public trustee". That's a county official who runs the foreclosure sales. In many counties, like Denver County, they publish all the info on their web site. The sale is held on Thursdays at 10:00 in the morning. On Tuesday afternoon, the trustee publishes a list of all the properties that are going to be sold on Thursday. This list includes the amount owed (which includes the mortgage balance, back payments, late charges, legal fees, filing fees, etc.), the opening bid and the amount of the deficiency. For perhaps 75% of the properties, the opening bid is the same as the amount owed and the deficiency is zero. After the auction is finished, the trustee publishes the results of the auction, including the winning bid, if there was one. On these properties where the opening bid is the full amount owed, there are rarely any bids. These go back to the bank and become REOs.

For a small portion of the properties the opening bid is some reasonable number. Reasonable meaning a price that should, and usually does, draw bidders. Most of these properties do get bids and are sold to someone. The difference between the winning bid and the amount owed becomes the deficiency and the bank will go after the borrower for this amount.

Based on my experience in trying to buy short sales and watching these auctions and researching some of these properties, I believe that if the bank thinks the owner has assets, they will start the bidding low and pursue a deficiency judgment against the owner. If they think they don't, the bank starts the bidding high and just takes it back. I'm not sure if they can pursue a deficiency judgment in this case or not. I do think the lender sends the borrower a 1099 for the forgiven debt. That creates a big tax liability for the borrower.

Strategic default is certainly an option. If the house is significantly negative, it may be financially very attractive. OTOH, when this person bought the house they thought they were paying a good price and agreed on the terms of the loan. Everytime someone buys a new car they are underwater as soon as they drive off the lot. Yet people keep those cars and make those payments. They don't say "hey, I'm underwater, you take the car". IMHO, a house you live in is no different than a car. Values go up, values go down. If it was a good deal when you bought it to live in, what makes it a bad deal if the value goes down?

If Joe does choose to default, there are consequences. His credit is going to be wrecked. He will almost certainly either get a 1099 for the phantom income for the forgiven debt or he will be pursue. There may be some way to avoid the tax consequences if the debt was strictly for acquisition or improvements of the property, or if he can show he is insolvent. The latter seems unlikely since he has those assets. The former wouldn't apply if he, like many people, took out a HELOC on the house when values where high and spent the money. If he took a HELOC or cash out refi and spent the money on those rentals, or cars and vacations, like many people did (remember the "wealth effect" discussions?) then that forgiven debt really is income.