Surprising short-sale impacts on credit

The higher the credit score, the longer it may take to fully recover

By Inman News Feed
Add Comment Add Comment | Comments: 1 | Posted Nov. 30, 2011

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The higher the credit score, the longer it may take to fully recover

Benny Kass
Inman News™

DEAR BENNY: What impact will a short sale have on my credit rating? Will it be better for me to let the property go to foreclosure? --Kristine

DEAR KRISTINE: That's a tough question to answer because, to my knowledge, the various credit rating agencies have different approaches to determining ratings. More significantly, once you start falling behind on your monthly mortgage payments, your credit rating is already falling, so its difficult to separate the bad credit from the impact of a short sale.

One of the most prominent credit reporting companies that mortgage lenders rely on is known as FICO -- formerly known as Fair Isaac Corp. In March 2011, under the heading "Research looks at how mortgage delinquencies affect scores," some interesting statistics were presented. To summarize:

  • there is no significant difference in score impact between a short sale, deed-in-lieu or foreclosure;
  • in general, the higher your score before you have financial problems, the longer it will take to fully recover; and
  • while a score may begin to improve in the short run, it could take approximately seven to 10 years to fully recover, assuming you are current with all other debt obligations.

The full study is reported at bankinganalyticsblog.fico.com.

DEAR BENNY: I am an estate planning and tax attorney in Chicago and read your solicitation for additional suggestions regarding your reader who asked about giving a home to his aunt. Here are a few thoughts.

First, you are correct that the Internal Revenue Service would likely not respect the reader's plan to make annual exclusion gifts of interests in the home to 35 people who would then each gift the interest to the aunt. The IRS would probably view this as a gift of the entire home directly to the reader's aunt on several possible theories.

There are several possible strategies for the reader to gift the residence to his aunt.

1. He could sell the property to his aunt in exchange for a promissory note and forgive the note over time as a gift. Generally, the IRS will respect this arrangement only if the transaction and debt is bona fide and there is no express or implied agreement that the reader will forgive the debt.

The reader would likely want to give the residence and the promissory note to his aunt under his will or trust. If he died before the debt was fully satisfied, his executor would probably have the duty to collect the debt. Also, the value of the remaining debt would be includible in his taxable estate.

2. If the reader could establish the home as his second home, he may be able to use a qualified personal residence trust ("QPRT") to gift the residence to his aunt. Basically, the reader would transfer the residence to a trust. The typical trust would provide full use of the residence to the reader for a period of years, and then would transfer the residence to the reader's aunt after the period.

The reader would be treated as having made a gift to his aunt, but the gift would be less than the fair market value of the home because the reader would retain the value of that initial period of use. During the period while the reader has the right to use the home, he may be able to lease it to his aunt.

3. The reader could just give the residence to his aunt. Much would depend upon the reader's personal wealth, future wealth and estate planning picture. However, assuming no prior taxable gifts, a gift of $460,000 or so to his aunt would not require the reader to actually pay gift tax.

He would be required to file a gift tax return, but the reader (and everyone for that matter) has a $5 million lifetime gift tax credit (at least through 2012) that allows the reader to give up to $5 million in lifetime gifts (not including annual exclusion gifts) and not pay gift tax currently.

4. The reader could keep the residence and lease it to his aunt. Why is it so important that the aunt be given the home if there is a clear understanding that she can live in it? If the reader leases the home to his aunt, he might generate a tax loss for himself while doing a good deed by allowing his aunt to live in the home at her leisure. He could even forgive some of the fair market rent as a gift each year.

Employing any of these strategies would obviously require a more thorough understanding of the reader's personal tax situation, wealth and other factors. --Clint

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1. Credit Rating Scores said... on Mar 28, 2012 at 09:05AM

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