What the Bailout Does for Mortgages – Speficially Yours

While many of the terms of the bailout have not been announced (since Congress only had 24 hours to read the 1000+ page bill, they might not know what’s in it yet), the basic framework of the mortgage portion has been announced (more details to be released on March 4.)  While there are positives, I think that for the majority of people in San Diego County, it is going to be more negative than positive.  With the limited information that we have now, here is why:

• Only loans that are guaranteed by Fannie Mae or Freddie Mac are eligible.  The problem with that is while at the peak of the market when many of these loans were made, the median price (including condos) in San Diego was over $500k, the limit for Fannie and Freddie loans was $415k.  So, most people in San Diego don’t qualify (Arizona is estimating only 19% of their loans are Fannie or Freddie, California is probably less).
• The first mortage must not be more than 105% of the home’s value.  That is fine, unless you bought in 2004-2006.  For example, if your first loan is $400k, you home value can not be more than $420k.
• Only first mortgages qualify.  If you have a second mortgage, it doesn’t get adjusted.  Most people I have worked with can handle the first mortgage, it is the second mortgage that pushes them over the edge, and that will not be adjusted.

As more details come out, I will provide more information, but for Californians, I don’t think the news will be good.  Whether you like Obama and think he is doing what is needed to solve the problems Bush started, or think the Democrats are taking this opportunity to take the country in a socialistic direction, the one thing that is very simple to understand is that the Democrats are in power, and like all politicians, they want to stay in power.  It is much more to their advantage to point the mortgage money into states that are boarderline Democrat so they can claim to be solving problems and pick up more votes where it counts.  There is not a large need for Democrats to help California because the state is as likely to vote Republican as Texas is to vote Democrat.  Not that it is good or bad, but as the party in power, the Democrats are going to try and keep that power by influencing borderline states.  California is not a borderline state, so I don’t anticipate the rules being writen to help us out.
I hope I am wrong, but we won’t know for sure until March 4 when the definitive rules come out.

Mortgage Foregiveness – May Work in More Situations

I spent several hours Friday on the phone with the IRS and reading through various sections of the Internal Revenue Code and think that I may have found a loophole for people who need to do a short sale or are being foreclosed on a rental property that used to be their primary residence.
Before I go into details let me once again state that I am NOT AN ACCOUNTANT or TAX LAWYER.  Please, use the information I will provide below and do your own research or hand it to your accountant to research.  DO NOT DEPEND ON THIS TO DO YOUR TAXES or SET YOUR FINANCIAL PLAN.

On Dec. 20, 2007, President Bush signed H.R. 3648, the Mortgage Foregiveness Debt Relief Act of 2007.  There are two portions of this law which are important for this discussion:

Section2.(a) which modifies Paragraph 1 of section 108(a) of the Internal Revenue Code of 1986 by adding subparagraph (E) “the indebtedness discharged is qualified principal residence indebtedness which is discharged before January 1, 2010.”

and

Section 2.(b) which adds, among other things, to the end of Section 108 of the Code section h of which paragraph 2 reads, “(2) QUALIFIED PRINCIPAL RESIDENCE INDEBTEDNESS. – For the purposes of this section, the term ‘qualified principal residence indebtedness’ means acquisition indebtedness (within the meaning of section 163(h)(3)(B), …”

The result of both these paragraphs are well known.  The first says that if your bank receives less money than you owe them during either the sale or foreclosure of your home, while the bank will still send you a 1099 for the “debt relief gain” (the amount you did not pay back), the Federal Government will not tax you on that gain if the sale or foreclosure is completed before January 1, 2010.   The second says that this holeds for Acquisition Indebtedness (the loan you took out to purchase your home).
There are two points to dig for a little deeper:  What if you re-financed your home, and what if it was your primary but is not any longer (you moved out prior to the sale)?

To look at the question of re-financed loans, I looked at section 163(h)(3)(B) which is below:

(B) Acquisition indebtedness

(i) In general The term “acquisition indebtedness” means any indebtedness which—

(I) is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and 

(II) is secured by such residence.

 Such term also includes any indebtedness secured by such residence resulting from the refinancing of indebtedness meeting the requirements of the preceding sentence (or this sentence); but only to the extent the amount of the indebtedness resulting from such refinancing does not exceed the amount of the refinanced indebtedness.

 

What does it mean?
This means (once again, my opinion only) that if you have re-financed your home, you are still covered.  If you pulled money out of the home and used it to improve the home, that money is covered also.  However, if you pulled money out of the home to buy toys or take vacations, that is not covered and you will be taxed on that portion.  For example:

Purchased home for $500k with 100% financing.
Re-financed pulling out $200k.
Put $100k into the yard.
Put $100k in Enron stock which is now gone.
Sell the house and the bank gets $550k back with $700k in loans so they lose $150k.
You will get a 1099 for $150k in gain (the amount the bank lost).
You cannot write off the $100k you used for Enron stock but you can write off the $50k of the loss that was put into improving your home.
Hopefully, you can show that all the money from your re-finances went back into the home.

Now, the second question is more interesting.  What if you didn’t live in the house at the time it sold?  The reason this is important is what if you had rented out your home when you purchased your current home and then have to short sell or foreclose on your current rental (former primary).  My reason for pursing this is that if you sell a home and have a capital gain (wouldn’t that be nice), you can exclude $250k of that gain ($500k for a married couple) if you lived in the home two of the previous five years.  Can we use the same rule here?

Well, Section 2 of H.R. 3648 also adds Section 108(h)(5) to the IRS Code that reads:

(5) PRINCIPAL RESIDENCE. – For the purposes of this subsection, the term ‘principal residence’ has the same meaning as when used in section 121.

Ok, back to the revenue code looking for section 121 (I know, get a life).  There it is.  Section 121(a):

(a) EXCLUSION
Gross income shall not include gain from the sale or exchange of the property if, during the 5-year peiod ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregatin 2 years or more.

What it means:

If you rented out your previous primary residence for a period of time once you purchased your current home, and you have to do a short sale or foreclosure on that home, if you lived in it 2 of the previous 5 years (based on the close date of the sale or foreclosure transaction), the home qualifies as a primary residence and you can exclude the “debt foregiveness gain” from your taxes.  Yes!

Summary

Many of you are learning to jump straight to the end as I spell things out in great detail.  The main points here are:

• I need a hobby
• Your may be able to exclude the debt foregiveness gain on your home even if you have re-financed, but only up to the amount that the refinance was used to absorb your purchase price and add any improvements, but not any funds used for anything other than your home.
• You may be able to exclude the debt foregiveness gain on a prior primary residence if you lived in that home 2 of the previous 5 years.
• However, what I suspect, and is the case with the client I did the research for, is many people refinanced their first home and used the extra money to purchase the second home.  The extra money used to purchase the second home is not eligible for foregiveness, you will still be taxed on that portion of the debt foregiveness gain.
• This says nothing about the right of the bank to pursue you for a deficiency.  If you have refinanced your home and the bank accepts less that full payment in a sale or foreclosure, they can pursue you for the balance.  That is why if you are doing a short sale, be sure to use someone who has experience (like the guy who needs a hobby) so that they can try and negotiate with the bank to give up their deficiency rights.

How Far Have We Fallen? Part 2 – 4S Ranch

It has been about a month since I posted my analysis of downtown San Diego and spent this week looking through the numbers for 4S Ranch.  For those of you who don’t know where 4S Ranch is, it is a master planned community that consists of roughly 4,000 homes (including the nearby communites that were built a couple of years earlier, but that are similar enough that they are included).  There are a couple of reasons for looking at 4S:

• It is a new (sales started in 2002) master planned community
• Because it is newer, there are a lot of loans made since 2004 when banks were playing fast and loose with money.
• Foreclosures have been moderate, but are poised to quickly increase.
• Because it has a lot of “troubled loans”, trends seen in 4S have and will lead the San Diego market by about four to six months.
• Because of the positives in the neighborhood (Poway schools (2 elementary, 1 middle and a high school in the neighborhood), easy access to I15 and Hwy 56, numerous parks and trails, and close proximity to employers and shopping – not to mention the great weather), 4S Ranch is likely to bounce back faster than some of the other master planned communities that do not have all these positive attributes – so we will see the turnaround start in 4S before San Diego in general.

I have tracked quartery sales in 4S, every quarter since the beginning of 2005 and it makes sense to break the market into three broad categories:  Detached Single Family Homes, Detached Condominiums, Attached Condominiums (For those of you familiar with the area, detached condominiums include: Tanglewood, Summerwood, Garden Gate, Garden Walk and Amante.  Everything else is self explanatory.)  So, let’s look at each group independently.

Single Family Detached Home Sales

These homes break into four categories by square footage (Ivy Gate is broken out as its own category based on uniqueness of the homes and lots and the fact that mortgage fraud that occured in almost 1/4 of the innitial purchases skews the current foreclosure numbers).  The two smaller catgories peaked (based on price per square foot) in the second quarter of 2005.  The two categories of larger sized homes peaked a couple of quarters later.  Since their peaks, each grouping of homes has fallen between 26% and 34%.  The drop in the last year has been between 9% and 12%.

Detached Condominiums

These homes break into four sections by square footage.  The peak prices are consistently in the third quarter and prices are off between 25% and 30% since then.  In the last year however, the drop has been between 3% and 7% as these homes fell in price first as models similar to both Tanglewood and Garden Gate came on the market in Amante and Garden Walk at lower prices than the re-sales were getting.

Attached Condominiums

The attached homes did not peak until the first quarter of 2007.  That is due largely to newer product that was superior coming on the market in late 2006.  Since the peak two years ago, the condos have fallen between 17% and 22%.

Same Home Sales

There were 25 homes that sold in the fourth quarter of 2008 that had also sold in the previous three years.  Rather than list each home, I will provide a quick summary:

• 9 of the 25 homes were foreclosures and 5 were short sales.
• The largest drop from the last sale was 31% and the smallest was 5%
• The average annual drop for all the homes sold in the fourth quarter that had also sold in the previous 3 years was 9.4%.
• Of the 11 homes with the largest annualized price reduction, 10 were foreclosures or short sales (the 11th was one of the aforementioned Ivy Gate homes).

Summary

The 4S Ranch neighborhood has seen a drop of roughly 25-35% since the peak of the market in late 2005.   A large percentage of the homes that sold in the fourth quarter that had been purchased within the past 3 years sold as foreclosures or short sales.   When the banks are involved through either a short sale or a foreclosure, they price the homes lower than the general market.  This can be specifically seen in two homes that were purchased from banks by investors and flipped within 3 months.  Each was re-sold for 26% over the price paid to the bank (these were purchased using agents on the mls, not at the Trustee Sale).  Given the amount of built in profit in those two sales, one can estimate that the true drop in the market is less than the 25-35% shown by the numbers because the current numbers include a high percentage of bank properties that are being sold at less than market value (it also means there are isolated opportunities where the banks are making large mistakes that investors can profit from).

Forecast

Prices are firming here in the first quarter and should remain strong until about April thanks to the moratorium on foreclosures by Fannie Mae and other banks.  We are starting to see more foreclosure homes hit the market now as the moratorium (for most of the banks) is over.  The inventory will start to rise in late spring, which could lead to downward pressure over the summer again.  I am going to take a risk and stick to my forecast that the fourth quarter of 2009 will end up being the bottom and that starting in the third quarter there will be a nice 1-2 year window of opportunity for investors in the neighborhood.