There's No Such Thing As a Free House, Even When You Win the Foreclosure Battle

Some homeowners are emerging from the housing crisis with “free houses,” according to a recent article in the New York Times.

According to the article, some homeowners are seeing the foreclosure cases brought against them dismissed because lenders missed key deadlines or because the statute of limitations has expired (here’s a nifty guide on states’ statutes of limitations on debt collection). Commenters vociferously debated whether these homeowners should be congratulated for winning their battles against their lenders or vilified for shirking their financial responsibilities.

In truth, the chance that most homeowners who fight foreclosure will walk away owning their homes free and clear are slim. They are “similar to unicorns,” says consumer law attorney Troy Doucet who practices foreclosure defense. “Their sightings are incredibly – incredibly – rare.”

Attorney and CPA Jo Ann Koontz also warns that there is a lot of confusion around this issue. “People think having a foreclosure case thrown out or having the lien released means the debt has gone away,” she says. “That’s not always the case.”

Even when homeowners “win,” there may be complications.

The Tax Aftershock

Canceled or forgiven debt can result in the issuance of a 1099-C to the homeowner — here’s a primer on how a 1099-C for canceled debt can increase your tax bill.

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Under the current Tax Code, most canceled debt must be reported as income unless the borrower qualifies for an exclusion or exception. Taxpayers in this situation may qualify for the insolvency exclusion or the Mortgage Forgiveness Debt Relief Act exclusion, which will allow them to avoid taxes on all or part of this income. But if they don’t, they could find themselves with a big bill from the IRS.

“Anytime the debt is canceled a 1099-C is issued,” says Koontz, who noted that she and her colleagues have been getting panicked calls from taxpayers who thought they automatically could avoid taxes on canceled mortgage debt, but found out that wasn’t necessarily the case.

A Home in Limbo

The Times article warns that lenders may place liens on these homes so that when the property is eventually sold they will be paid from the proceeds. A lien on the home could remain indefinitely. Doucet explains:

The lien would remain on the property until the client had it removed, unless the bank agreed to voluntarily remove it. If the bank didn’t voluntarily remove the lien, the homeowner would almost certainly need to file a quiet title action to remove it. However, ‘free houses’ are so rare, I doubt any recorder’s office would allow the release of the mortgage short of a court order. Even if the recorder did have it removed, future title companies would likely be uncomfortable issuing title insurance without a court order.

Koontz agrees that just because the debt goes away that doesn’t automatically mean the lien does. Legally, she says, “If the debt is forgiven then the lien goes away.” But from a practical standpoint it may not be so simple. She says borrowers in this situation should ask the lender to file a release of lien or satisfaction, which will remove the lien from the property and the public record.

As far as credit reports go, defaulted mortgage loans may appear on consumer’s credit reports for seven years from the date they were charged off. You can get your free annual credit reports on AnnualCreditReport.com and you can get a free credit report summary every month on Credit.com.

If the lien remains, the homeowner is in some sense getting free “rent” rather than a free house. If the home’s value appreciates, the homeowner could sell the home, pay off the loan and still walk away with cash in his or her pocket. But if it remains underwater it’s a different story.

In the meantime, the homeowner will still incur costs, including homeowner’s insurance, taxes and maintenance. That still may be a bargain compared to rent in many cases, but it’s a far cry from walking away with a free and clear title to a property.

And it could be worse, Doucet warns. If the lien is determined to be valid, interest may continue to accrue, “eating away any equity on a compounded interest basis.” He warns that homeowners could also end up spending significant time and money trying to get the lien removed through litigation. Says Doucet: “Thus, that free house doesn’t really end up being free.”