'Sham' transfer of title can bring grief from IRS

Nation's Housing

November 12, 1995|By Kenneth R. Harney

WASHINGTON -- Hundreds of homeowners unknowingly may be setting themselves up for federal tax audits, costly penalties and negative credit reports by participating in commercial programs that promise to get them out of hot water with their mortgage lenders.

One firm claims to have helped 2,100 financially distressed homeowners in 40 states during the past year and a half at a minimum fee of $1,000 per property. The same firm has been sued by the California attorney general for alleged marketing misrepresentations. Moreover, the Internal Revenue Service has warned that homeowners who participate in "sham" transfers of title to their property to avoid federal taxes could end up owing "appropriate penalties" as well as back taxes and interest.

The "distressed homeowner" programs are most commonly marketed in areas where real estate values have declined or been flat in recent years. The main targets are homeowners who find themselves in negative equity positions, owing more on their mortgage than the property could bring at sale.

For such owners who no longer can -- or choose not to -- make monthly mortgage payments, the programs offer what appears to be a clever way out. After the homeowners pay a cash fee ranging anywhere from $1,000 to 1 percent of the original mortgage amount, the promoters of the program step in and take title to the house.

The promoters then list the house for sale, notify the lender to expect no further payments on the mortgage, and inform major credit-reporting agencies that they -- not the borrowers -- will now be responsible for any delinquency or foreclosure action taken by the lender. If the property sells before the lender forecloses, the promoters send the net proceeds -- usually thousands less than the mortgage debt owed -- to the lender.

This is known in the trade as a "short sale." If the property goes to foreclosure, the lender also typically recovers far less than the homeowner's outstanding balance.

Now for the rub: Under federal tax law, whenever a taxpayer is relieved of debt, he or she is deemed to have received income. For example, if you owe $100,000 on your house, but your lender takes $80,000 through a short sale, you were relieved of $20,000 in debt.

For tax purposes, that's the same as someone handing you $20,000 in cash.

The IRS requires creditors to report the identities of persons who receive debt relief in excess of $600 by sending Form 1099s to the taxpayers and to the IRS. The IRS then routinely runs computer matches of the 1099s sent in by creditors against the tax filings of the individuals identified by the lenders.

"People are buying into the idea that by simply deeding over their house to a third party, they can extinguish all their responsibilities," said California Deputy Attorney General Dennis W. Dawson. "That's just not the case."

The upshot for homeowners? Unless you enjoy IRS audits, proceed with extreme caution and solid legal advice.

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