Ask Liz Weston

Dear Liz: I lost my job 18 months ago. I am 61 and have back pain that keeps me from standing more than 15 minutes or sitting more than two hours before I have to lie down, which limits my job prospects. I arranged a short sale of my home a year ago to avoid a foreclosure, and recently received a 1099-C form from the lender for $99,000 of forgiven debt. Please warn others about this!

Answer: Don’t panic just yet.

Normally when a lender cancels or forgives debt, you have to include the forgiven amount in your income for tax purposes, which can result in a whopping tax bill.

But the federal Mortgage Forgiveness Debt Relief Act of 2007 provides an exception for homeowners who lose a home to foreclosure, sell it for less than they owe in a short sale or have their debt reduced through a mortgage modification.

You still have to report the forgiven debt on IRS Form 982, but it’s typically not included in your income for federal tax purposes if:

• The home was your primary residence (second homes, vacation property and rentals don’t qualify).
• The forgiven debt was $2 million or less ($1 million for a married person filing separately).
• The debt was forgiven in calendar years 2007 through 2012.

For more information, visit the IRS’ website at http://tinyurl.com/5pe43f. Details can also be found in IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments.

You’ll have to do a little research to see what you might owe under your state’s income tax laws, which could differ. California, for example, hasn’t updated its law to conform with the federal law for mortgage forgiveness occurring on or after Jan. 1, 2009, although there are several bills pending in the Legislature to do so.

If you’re in California, you might want to bookmark this Franchise Tax Board page at http://tinyurl.com /yhx89zw and check back before filing your taxes April 15 to see if you get any relief.

If, like millions of others, you can’t afford your mortgage payments and are getting the run-around from your loan servicer, you may be considering whether or not to walk away from your home.

Before you decide, you need to read Stephen Elias’ book “The Foreclosure Survival Guide.” It’s published by Nolo, the self-help legal publisher, and is the best guide I’ve found for dealing with this nightmarish prospect.

It’s well worth the $16 you’ll spend to buy it at Nolo or Amazon. But now it’s available absolutely free on Nolo’s Web site. You don’t get a physical book or a download, but you can browse every single page on the site.

photo credit: Mike Licht, NotionsCapital.com

Credit expert John Ulzheimer reports a disturbing development: a decision by the credit reporting industry to report loan modifications as “partial payment plans.”

From John’s blog:

The issue at hand is how very large mortgage lenders, namely Citigroup, Chase, and Bank of America, may report mortgage loan modifications to the credit reporting agencies and, secondly, how that credit reporting impacts the consumers’ FICO® credit scores. According to the Consumer Data Industry Association, the credit bureaus have agreed to guidelines that loan modifications will be reported as a “Partial Payment Plan.”

The problem with this decision is that FICO credit scores interpret the notation of a “Partial Payment Plan” as negative. Consumers will see their scores decrease some amount of points because of such a classification. How much their scores decrease will depend on from where their scores started.

John notes that modifications typically involve a reduction of interest rates, not balances owed, and are often temporary. Since the lender is not losing any principal, it’s hard to imagine how the “partial payment plan” notation is justified

To read his full blog post, CLICK HERE.

Dear Liz: I’m curious about your recent answer to the folks asking about a short sale. In it, you said, “Short sales . . . typically harm credit scores as much as foreclosures do.” As a real estate professional, I am under a different impression.

Certainly, in financial distress, one’s credit score takes a beating, but I don’t believe there is a code or classification for short sales on credit reports. We generally encourage short sales when possible as we feel short sales allow a debtor to get back on their feet quicker. I’d appreciate other data if you have it, as this would change how I educate clients. I do think we may see some changes in the future. As the number of short sales increases, we may see some way to note such transactions on credit reports.

Answer: The information about how credit scores are affected by short sales comes directly from FICO, the company formerly known as Fair Isaac Corp., which created the leading credit scoring formula.

You’re right that the formula has no specific code for a short sale, which is when the lender agrees to accept the proceeds of a home sale as full payment of a mortgage, forgiving whatever additional balance is owed. But most lenders report short sales as a debt settlement, which has a strongly negative effect on credit scores.

In many cases, the borrowers’ scores were already trashed by late payments and by the notice of default, which is filed by a lender after several skipped payments. A settlement notation or a foreclosure just makes a bad situation worse.

But you may have a good point about the debtor potentially being able to bounce back faster with a short sale. The foreclosure process can drag on for months, and sometimes more than a year, with each missed payment causing additional damage to the borrower’s score. Arranging a short sale may help a borrower put an end to the credit damage so he or she can start the long road back to better scores.

Dear Liz: We bought a house five years ago for $410,000 that is now worth $250,000. Meanwhile, our income in the last year has decreased by about $30,000 annually. We are trying to work with our lender to stay in our house, but things are tight and we don’t know how much longer we will be able to keep making payments on this house.

What would be the downside of doing a short sale, renting for a couple of years until we could buy again? It seems like we would be able to save up while we were renting, and I can’t see house prices doubling in the next two years. What do you think would be our best option?

Answer: You’re right that home prices won’t recover their lost value any time soon. But that alone isn’t good reason to bail on a mortgage, particularly given the fallout such a move can have on your finances.

The damage to your credit will be significant. Short sales — selling a home for less than what’s owed, with the lender’s consent — typically harm credit scores as much as foreclosures do.

And these days it’s harder to recover from a serious credit blow than it used to be. Fewer lenders are willing to take chances on those with subpar credit.

You may be able to qualify for a mortgage again within a couple of years, but you’ll probably pay higher rates for all your credit for several years.

If you can’t work something out with your lender and can no longer afford the payments, you may not have much of a choice. But given the stakes involved, you should explore all your options for saving the house before you turn in your keys.

The head of the International Monetary Fund says the U.S., Western Europe and Japan are already in one, yet there’s no standard definition of what comprises a depression.

My MSN colleague Jon Markman says it’s two back-to-back recessions, which would technically make the recessions of the early 1980s a depression.

Others believe it’s when the economy contracts for a more extended period, with five years being a commonly-cited length of time—which means the economic decline Japan experienced in the 1990s counts as a depression.

In the U.S., however, whenever we hear “depression,” we think “Great Depression,” the contraction that started after the 1929 crash and lasted until World War II.

At this point, it’s stretching credibility to imagine we could return to those days of 25% unemployment and one third of the nation “ill-housed, ill-clad and ill-nourished,” in FDR’s famous assessment. Especially in its early years, the Great Depression was a terrifying period of widespread want and uncertainty.

As I’ve said before, many of the safety nets that will prevent such widespread poverty were put into place during the Great Depression, including:

• Unemployment benefits
• FDIC insurance
• Social Security
• Food stamps

But millions of people are already experiencing a sharp drop into their standard of living as layoffs and foreclosures mount. So even if we don’t face the next Great Depression as a nation, many people are already experiencing a depression their personal finances.

Which is why it’s so important to get a handle on your finances now if you’re among the vast majority that still have homes and jobs. Build up that emergency fund, pay off that toxic debt, and protect your credit score. But don’t give in to panic and despair, because those who do are likely to miss some amazing opportunities.