Prospective client:       If I file a chapter 7 bankruptcy won’t the $50,000 in credit card debt I owe  be wiped out (legal term is discharged)?  

Me:  Yes – in most cases it would be “wiped out” unless there is some type of fraud on your part or the debt was incurred just before you filed for Chapter 7 bankruptcy. 

Prospective Client:      If I tell my credit card company that I may file for bankruptcy won’t they be more willing to make a deal with me and settle for a small amount of the original debt?

Me:      Many times a creditor will be willing to take much less than what is owed if they think you will be filing bankruptcy.

Prospective Client:      That would be great – then I can get out from under this debt and not have to file for bankruptcy (which is something no one wants to do). 

Me:      It is great – but you need to realize that the creditor is required to issue you a 1099 for the amount of debt that was reduced (i.e. forgiven) and the amount reported to the IRS on the 1099 will be taxable income to you.

Prospective Client:  What?

Me:        Under the tax code, the amount of the debt that is forgiven is considered income to the debtor.  For example, if you have $50,000 in credit card debt and you are able to settle the account by paying $10,000, you will be issued a 1099 by the creditor for $40,000 and you will have to pay income tax on this $40,000. 

At this point the potential client is usually somewhat confused and not at all happy.  While it is much better to pay tax on $40,000  (approximately $8,000 to $12,000 depending on your tax rate) then to pay $40,000, people who are calling me to discuss bankruptcy are usually in very difficult financial situations and paying either creates a big problem.  It is also important to note that under the bankruptcy code it is usually very difficult to get tax debt discharge.  Thus, while you may be able to have the $50,000 in credit card debt discharged, if you reach a settlement and then end up with a $12,000 tax debt you cannot pay, it may be very difficult to get this tax debt discharged in bankruptcy.

The forgiveness of debt income problem in many cases is the deciding factor to filing a bankruptcy.  Under the law, debt that is discharged (i.e. forgiven) in a bankruptcy case does not result in forgiveness of debt income.  The other major exception to the forgiveness of debt income rule is the Mortgage Forgiveness Debt Relief Act of 2007.   This law was passed by Congress to help address the current mortgage crisis in the housing industry and allows up to $2,000,000 in debt to be forgiven during the years 2007 to 2012 without resulting in income IF the debt was secured by your principal mortgage.

If you are trying to negotiate yourself out of debt, you need to be aware that any debt forgiven by your creditor in most instances will be considered taxable “income.”   Being aware of this will allow you to consider all your options and make the best choice.  The rules are complex and you should always consult with an attorney who is familiar with bankruptcy to help determine your best option.

1. Don’t sign any document you have not read!  Whether it is a loan document, a lease, a supply contract or anything else in writing – if you have not read it – or had your lawyer read it for you – do not sign it.
2. Don’t classify a person working for you as an independent contractor unless you know what you are doing.  It is a common practice to treat a person as an independent contractor instead of an employee to “save money.”  Unfortunately, the amount of money you save may not be that significant and any savings will pale in comparison to the back taxes, penalties, and interest you will owe if the Commonwealth audits you and determines your classification was wrong.
3. Don’t loan money without an agreement and security.  If you decide to help out a customer by loaning them money, make sure you have the terms of the agreement in writing and if at all possible get security (e.g. a mortgage on some real property they own).   If you do get security, make sure it is worth something.  For example, if a customer gives you a mortgage on their house – and yours is the 4^th mortgage where the total debt secured vastly exceeds the value of the house – you really don’t have much.
4. Keep good books!  Although this is much more of an accounting rather than a legal issue, I meet with too many business owners who do not have good records and do not understand the finances of their business.  Many times people love what they do – but don’t really like the “accounting” end of the business.  Keep good books, send out your bills promptly, and stay on top of your accounts receivables!
5. Always, Always Pay Your Trust Fund Taxes.  Paying your taxes is important but paying your trust fund taxes is very, very important.  The most common trust fund taxes include sales/meals  tax and the employee portion of withholding taxes.  The government views this money as their money – and if you don’t pay it to them as required it is considered theft.  If you are unclear about what I am talking about – you need to get a good payroll company and bookkeeper now.
6. Have a written agreement with all co-owners.  If you have others who own a part of your business you should ALWAYS have your agreement in writing.  It does not have to be a 30 page agreement that your lawyer will charge you a fortune to prepare but it should be long enough to cover the core terms: What is the percentage of ownership by each owner?  Who has the power to make decisions?  What happens if an owner wants to leave – or leaves unexpectedly (e.g. dies or is disabled)?  How much are the owners paid for working in the business?  What happens if the business must have an infusion of cash?  These are all questions you should address in writing when there is more than one owner of a business.
7. If it seems too good to be true it probably is.   This is a very old saying but it is still true.  I regularly read a good blog about business practices in China.   Dan Harris of  Harris & Moure of Seattle Washington put it very well when he stated in part as follows: “We love to write about the China scams (e.g. too good to be true) because they make great cautionary tales for our readers.   We always get comments about whomever it was who was duped was ‘incredibly stupid.’  I disagree. What usually has happened is what always happens.  I do not see these things as hinging so much on one’s intelligence. I think these sorts of things happen when the ‘making money portion of our brains’ takes over and overwhelms the deep thinking part of the brain and thereby renders it fairly useless.  I do think it happens more often to those new to international business and overly excited about its prospects. These are the people who ‘check their brains at the gate’ when arriving in China.”  Make sure that the “making money” portion of your brain does not overwhelm the “deep thinking” part of your brain.  No matter what the transaction – be sure not to “check your brains” when analyzing if it will be a good deal.
8. If you don’t have a business attorney you can regularly confer with – get one.  It is impossible to be good at everything you do.  Skilled business owners know what they are good at and know when to bring in expertise to assist them, whether that is a good payroll company, bookkeeper, or attorney.  Having a good business attorney to consult with as needed is essential in helping to insure that your business not only continues but thrives.

Following each of the above 8 steps will help keep your business on track.

What are your options?

If you have equity in your home and a steady income you may be able to refinance your mortgage with a new lender and obtain a better rate then you could obtain through a modification. However, if you are late on your mortgage payment and your credit score has declined, your ability to refinance with a new lender may not be a viable option. You also should consider your ultimate goal. Do you want to stay in your home? Is there any equity in your home? Can you sell your home and walk away with cash? Do you have other debts? Should you file for bankruptcy? These are all questions that you should evaluate before deciding if it would be beneficial to request a loan modification.

How does the loan modification process work?

All lenders are different but the overall process is the essentially the same. You, as the borrower, need to call you lender (and yes – be prepared to wait on the phone for some time) and request a loan modification. You will likely be directed to the mortgage workout or distressed loan group. Once you get to the correct person you will be asked to complete a detailed application which lists your current financial status. This information will be used by the lender to evaluate if a loan modification will be offered to you. A lender does not have to offer you a modification. However, the last thing lenders want is another property in foreclosure.

Be careful to analyze the terms of any modified loan.

If your lender offers a modification, be careful to understand exactly what is being offered. Before you start to analyze the new terms of the modified loan you should know the following facts about your current loan:

1. What is your current balance – i.e. how much do you think you owe?
2. What is your current interest rate – is it fixed or variable?
3. What is the remaining term of your loan – i.e. in how many years are left? and
4. What is your currently monthly payment – and does it include payment of taxes and insurance?

You should compare the above items from your existing loan with the offer from the lender for the modified loan. If the loan balance under the modified loan increases significantly over the amount you think you owe now make sure you understand how the lender arrived at that new loan amount. Does the new loan amount include significant penalties, interest, legal fees etc. While you may not be in the best bargaining position to demand any changes, at the very least you need to understand what you are agreeing to do. A comparison of the new rate and the length of the loan is very easy to make. If your interest rate was a 7% variable rate note and the lender is offering you a 5% fixed rate that is very good. If the rate goes up, or goes from fixed to variable (not likely to happen but possible) that would not be in your favor.

Does the modification lengthen the term of the loan? If you loan is currently set to expire in 10 years and the modified loan is 15 years you should know this fact. The addition of extra years is one of the ways that lenders use to reduce your monthly payment and also pay back past due amounts. While it is never good to add more years to the loan, the benefit of reducing the monthly mortgage payment may justify the extension of the loan term.

Finally, how does the modification impact your loan payments? Are you having trouble paying your mortgage because of a temporary or permanent issue? If the problem was temporary, you may not need a reduction in the monthly payments. If it is a long term problem, a reduction in payments may be a necessity. If you need a payment reduction be careful to understand if the payment being offered includes taxes and insurance. If the payment number is $600 lower than your current payment but does not include taxes and insurance, then you may not have any real savings. Make sure you are making an accurate comparison of any modified payment figure.

If you need a mortgage modification it is imperative that you understand what is being offered so you can try to negotiate the best deal possible. It never hurts to ask if something else can be done. With the current flood of bank owned properties the lenders may be more willing than you think to work with you so you can stay in your home.

Help – I am underwater!

Assuming the person is not speaking literally (e.g. the house is next to a river that has just flooded), when someone says the property is “underwater” they mean that the outstanding mortgage on the property exceeds the fair market value of the property.  A “short sale” means that the property is being sold for less than the outstanding balance due on the loan.    

How did this happen? 

Unfortunately, when there is a downshift in the economy and home values are impacted, it is all too common for a home to be worth less than the outstanding balance of the current mortgage.  In most instances, homes that are underwater where either: 

1. Purchased at the top of the real estate market; and/or

2. Purchased with very close to 100% financing. 

In some cases, even when a buyer paid 20% down for the property but purchased the property at the top of the market, the decline in value has exceeded the 20% down payment and the property is now worth less than the mortgage amount. 

What to do if I am selling a home that is underwater?

If you find yourself in a situation where you need to sell your home that is underwater, you should  contact your lender and ask what procedures they have to approve a short sale.  If you are selling your home, you are required to give the buyer good title to the property.  To give “good title” you need to make sure the current mortgage is released.  In a typical sale, once the bank is paid off it will release the mortgage.  Unless you have the money needed to make up for any shortfall between the sale price and the outstanding mortgage, you have to have an agreement from the lender to release the mortgage when the loan will not be paid in full from the sale.    

For example, you want to accept an offer to sell your house for $300,000 but you owe $350,000 on the mortgage.  Unless you can come up with the $50,000 to pay the balance due to the lender, you will have to get short sale approval from the lender.  If you are selling the property, you want the lender to agree to release the mortgage and not pursue you for the balance due.  How the lender will react to your request depends upon the lender and the situation.  Some lenders will review the situation and simply let you walk away from the loan after the lender receives the proceeds from the sale.  These lenders are hard to find.  Other lenders will require that you sign a new promissory note where you are required to pay them the balance over a period of time – e.g. a $50,0000 note payable over 10 years.  Sometimes the note will be at a low interest rate or even no interest.  Sometimes there will be a discount if you pay off the amount in less than the agreed upon time.  For example, you can pay $20,000 within 18 months to prepay the note instead of the full term of the note. 

If you are in a short sale situation and the lender is demanding that you sign a note for the balance due, this would be a good time to explore the possibility of a bankruptcy.  You should also make sure you disclose to any buyer that you must get approval from the lender to complete the sale.  It is important that the buyer be aware of the short sale situation because it is likely that there may be delays.  If your property is underwater and you can still make the mortgage payment, your best hope may be a rebound in the real estate market to increase the value of your home and thereby rescue it from its current underwater grave. 

What to do if I am buying a house that is underwater?

If you are the buyer of a home that is underwater it is important that you work with an attorney so that you can be sure all the liens on the property will be properly released.  Make sure you ask the closing attorney what liens are on the property and confirm that the current lender has agreed to release the liens even though they will not be paid the full amount due on the loan. 

When you are buying property in a short sale a typical problem is the possible delay in getting approval from the current mortgage holder.  Working with banks to obtain approval can be very frustrating and time consuming.  The seller may be doing everything within their power to get the short sale approved, but the bottom line is that the final approval of the short sale is outside the control of the seller and banks can sometimes take a very long time to approve a short sale.  If you are selling a property and need to move into a new home on a specific date, buying a house in a short sale may not be a good idea unless you have a back-up plan for living arrangements on a temporary basis.  In contrast, if you are currently renting and have the ability to stay in your apartment for a few extra weeks or months, or you are buying the short sale property to use as a rental property the timing of a short sale is of less concern. 

What now? 

Selling or buying a property in a short sale presents unique challenges for the seller and the buyer.  You should be prepared for the potential delays and it is more important than ever to work with an experienced real estate attorney, Realtor experienced in short sales and your financial or tax advisor to help guide you through the process.