My Housing Story - Part 4

This is part four in a six or seven part series recounting my California home ownership experience. For the first three installments, see:

• Part 1 - The newlyweds and the new house (1989-1992)
• Part 2 - Becoming a renter and a landlord (1993-1994)
• Part 3 - The new purchase and the lucky timing (1995)
  

Part 4 - The short sale and the lucky tax breaks (1996)

So, what do you do when you are upside down on your mortgage and you have to leave town because your employer just relocated and increased your commute from 45 miles to 70 miles?

You rent the place out and hope that things will turn around.

Even if you're losing hundreds and hundreds of dollars each month in cash flow, you can still get some of that back from Uncle Sam on bags of fertilizer, shrubbery, and all sorts of other purchases that somehow get redirected to your primary residence rather than being used at the rental property, as originally intended.

A near-obsessive desire to ensure that everything is OK at the rental house by making a 200 mile round trip almost every week (at least as far as the IRS is concerned), well, that helps too.

But, what do you do when your excellent tenant decides to leave town and you are faced with the choice of either:

1. replacing your excellent tenant with maybe a not-so-excellent tenant and continuing the monthly cash drain
2. dumping the place, just like everyone else was doing
   

Well, that's easy. Screw the neighbors - do a short sale!

The last time this happened

Prior to the mess that is currently unfolding, the last California real estate cycle peaked in 1990-1991 and made a bottom in 1995-1996. Early in the 1990s, when homeowners first began having difficulties making their mortgage payments due to job loss and other reasons, banks were tough on the borrowers.

If you owed more than the place was worth and you wanted to sell, you'd have to write a check and bring it to the closing in order to get the deal done.

After a few years of bank owned property piling up at a quickening pace and as boarded-up homes with brown lawns began dotting neighborhoods all over Southern California, banks became much more willing to talk to borrowers who were in trouble.

They began to welcome short sales because that would be one more house that gets off of their books quickly rather joining the fast growing inventory of bank owned property quickly falling into disrepair.

By 1996, real estate agents who specialized in short sales were commonplace and after a few days of faxing all sorts of information back and forth, it was agreed that the bank would get all of the net proceeds from the sale and that we would not be required to make any subsequent payments to the bank.

The purchase of a new house in North Oxnard the year before had virtually assured that we'd have no money left over at the end of the month for the lender to stake a claim on and, just to make sure, we went out and bought a new car.

Based on comparable sales, the Palmdale home was listed at about 35 percent less than what we paid seven years before and it ended up selling for an even 40 percent below our original purchase price.

We didn't care!

We had put no money down, already had a new house, had just purchased a new car, and figured we could ride out the ding to our credit. We continued to apply for credit cards and were never turned down. The short sale showed up as a foreclosure on our credit history on only one of the three credit rating agencies, so we were even able to refinance a few years later with no adverse consequences.

It all seemed too good to be true, but it was.

The tax man cometh, but leaveth poorer

As this was a VA loan for a short sale property that had been converted into a rental prior to being sold, it presented a fair number of difficulties when tax time came. Our tax preparer, who also taught tax accounting, was so taken with our case that it was used as a classroom example.

To make a long story short, the only real obstacle in wiggling out of this with a minimum tax liability was getting our net worth as close to zero as possible so that the dreaded "debt forgiveness tax" (that Congress is now trying to repeal) would be minimized.

There were many tens of thousands of dollars of debt being forgiven in this case, however, only the amount of forgiven debt that exceeds your net worth is taxable.

Naturally, having just used all our available cash to purchase a new home the year before that had declined in value since we bought it, well, this helped out quite a bit in reducing our net worth (this was back in the day when, aside from VA and FHA loans, you had to put at least ten percent down). And, after a few other moves were made, a "snapshot" of our assets was taken on the day that the sale closed and the "debt forgiveness" tax bite was relatively small.

On the opposite side of the ledger was the capital loss on the property from the time that it was converted into a rental property until the time that it was sold. This turned out to be a significant dollar amount, handily offsetting the taxable debt forgiveness, and the end result was a tax refund of thousands of dollars.

The best part of the deal was to follow about six months after the house was sold...

You see, the first thing that you do when you decide to do a short sale is you stop making payments - if you continue to make your monthly payments, the bank won't take you seriously and they'll just keep cashing your checks. So, after you stop making payments, it becomes the bank's responsibility to pay the taxes and the homeowners insurance.

At this point, you and the bank are partners (as never before) and they want to make sure they don't come up empty handed if the place burns down (these things happen). In our case, just prior to the short sale closing, the bank had just mailed a check for the homeowner's insurance premium of about $600.

As the insurance company was legally required to refund the unused, prorated balance to the homeowner regardless of who actually paid the bill, a check for about $500 showed up in the mail - a nice little bonus, courtesy of our first housing bubble experience.

Epilogue: Sometimes it's hard to believe how much things have changed in the last eleven years. From a near-zero net worth in our mid-thirties to a comfortable retirement from normal working life today - writing this blog and an investment newsletter far away from big cities and crowded freeways.

I guess living through two housing bubbles has been a pretty good experience for us - learning from the first one was the key. Of course we rent today, but we do look forward to buying again when the time is right.

Next up: Part 5 - The rising home equity and money for nothing (1997-2003)