On November 27, 2012, the New Jersey Real Estate Appraisers Board issued an opinion holding that a Broker Price Opinion (BPO) is an appraisal under New Jersey law, and that preparation of BPO’s by persons such as real estate
brokers who are not appraisers licensed under New Jersey law is illegal and subject to penalties. However, the
Board also noted two exceptions in the law which would allow real estate brokers to lawfully prepare BPO’s. One of
those exceptions allows persons other than appraisers to prepare BPO’s for the purpose of giving counsel and advice
directly to a property owner or prospective purchaser on pricing, listing, and selling of real property. This
exception means that a BPO prepared for a relocation management company (RMC) to assist in its purchase of a home from a transferring employee will continue to be a proper and legal procedure. The Board’s full opinion can be
The Full Story:
The New Jersey Real Estate Appraisers Board is an official state board responsible for the regulations and licensing
of real estate appraisers in the state. Among its other activities, it is authorized under state law to investigate
and penalize individuals who engage in the unlicensed practice of real estate appraising. It has no authority over
the licensing of Realtors, but could penalize a Realtor up to $20,000 for the preparation of “appraisals” without a
real estate appraiser license. Consequently, its determination that a BPO is an “appraisal” could create
significant difficulties for Realtors preparing them unless the preparation is excepted from the general rule that
appraisals may only be prepared by licensed appraisers.
Under New Jersey law, only licensed real estate appraisers may prepare real estate appraisals. However, section
45:14F-21 (c) of the New Jersey statutes provides an exception as follows:
“Nothing in [this law] shall be construed to preclude a person not licensed or certified…from giving or
offering to give, for a fee or otherwise, counsel and advice on pricing, listing, selling and use of real property,
directly to a property owner or prospective purchaser if the intended use of the counsel or advice is solely for the
individual knowledge of our use by the property owner or prospective purchaser.”
The Board interpreted this provision to apply when the broker “is engaged in a transactional relationship” with the
owner or prospective purchaser of specific property, and has a “commercial and/or professional relationship” with
In the relocation home sale process, companies or RMC’s solicit BPO’s (sometimes called Broker Market Analyses
elsewhere) to determine the listing prices or offer prices of a transferee’s property that the company or RMC will
eventually purchase. The broker has a commercial, transactional relationship with the company or RMC as a
prospective purchaser. Often, the broker will ultimately get the listing for the property. Consequently, there
seems little doubt that the use of BPO’s in the relocation home sale process in New Jersey is not impacted by the
The Board expressed concern about BPO’s used for such purposes as tax appeal proceedings, judicial or quasi-judicial
proceedings where the value of property is an issue to be determined, loan origination, and by mortgage service
companies or asset managers for short sale valuations, loan modifications, etc. It expressed no specific concern
with use of BPO’s to assist sellers and buyers to determine the proper price for the property.
Consequently, it does not appear that this opinion will have any impact on the use of BPO’s in the mobility
Posted by Peter K. Scott
Many Worldwide ERC® member companies compensate relocated employees who must sell their house at a loss. In
computing a compensable loss, companies sometimes compare the amount received on the sale with the employee’s purchase price plus "capital improvements" made to the house while owned by the employee. Determination of whether expenditures are for capital improvements or are properly treated as repairs or maintenance expenses is critical for
employers/employees from both a policy and a tax standpoint.
The Full Story:
Today’s tax quote: “Last year I had difficulty with my income tax. I tried to take my analyst off as a business
expense. The Government said it was entertainment. We compromised finally and made it a religious contribution.”
Like Woody Allen’s troubles with his analyst, countless taxpayers have argued with the IRS over how to treat
expenditures they made on their property, and the area sometimes remains just as muddled.
An enormous body of law, reflected in court cases as well as in IRS rulings and regulations, defines the difference
between a "capital expenditure" which is added to the cost basis of a residence, and a "repair" or "maintenance
expense" which does not affect the cost basis. While the principles developed by this body of law set certain
boundaries, there is ample scope for interpretation and analysis in applying the principles to the particular facts
of a specific case.
Moreover, some of the law is influenced by the context in which the issue arises. For example, in a business
context, the taxpayer ordinarily does not want expenses classified as capital expenditures because such costs are
added to basis and not currently deductible as business expenses. In 2011, Treasury published an extremely lengthy
set of temporary regulations in an attempt to bring further enlightenment to this area, but it remains a factually
A homeowner, on the other hand, cannot deduct expenses and would ordinarily prefer that costs be added to basis.
Since the addition of the principal residence capital gain exclusion in 1997, this is less of a problem because gain
on a principal residence is usually excluded from income and basis is less important. However, the issue of what
counts as an “improvement” or “betterment” remains crucial to determining loss on sale in those programs in which
capital improvements are counted.
A "capital expenditure" is defined as an expenditure made with respect to property which adds to the value of the
property, substantially prolongs its useful life, or adapts the property to a different use. A "repair," on the
other hand, neither materially adds to the value of the property nor appreciably extends its useful life, but keeps
the property in an ordinarily efficient operating condition. The body of law defining which building improvement
expenses are capital has been developed largely in commercial contexts and has not dealt directly with many types of home improvements.
The principal source of guidance for homeowners on this subject is in Publication 523, “Selling Your Home.” The
Publication includes a helpful chart listing some common improvements. For example, IRS recognizes that the
following home improvements are capital improvements the costs of which are added to a home’s basis:
- putting a recreation room in an unfinished basement;
- adding another bathroom;
- adding another bedroom;
- putting up a fence;
- putting in new plumbing or wiring;
- putting on a new roof;
- paving the driveway.
The Publication also lists such items as heating and air conditioning systems, plumbing, wall-to-wall carpeting, new kitchen appliances, sprinkler systems, and swimming pools.
In Publication 523 IRS maintains (with substantial case support) that repainting a house (inside or out), fixing gutters, mending leaks, plastering, and replacing broken windowpanes are mere repairs, the cost of which is not added to the basis.
If, however, the repairs are done in the context of an extensive remodeling or restoration job, all expenses of the job are capitalized. For example, the costs of repair after a casualty are usually thought to fall into this capitalization category.
Beyond this sparse guidance from the IRS, court decisions concerning expenses with respect to commercial buildings give clear support for capitalizing at least some types of home improvements. For example, it is clear that the following improvements give rise to capital expenditures: landscaping; underground sprinklers; swimming pools; tool sheds; major building systems such as a furnace, air conditioner or hot water heater; built-in appliances such as a refrigerator, stove, oven or garbage disposal; skylights; installing or moving a permanent light fixture; replacing a bathroom fixture; retiling floors or walls; and replacement windows. In contrast, expenses for jobs such as tree-trimming, termite treatment, and routine maintenance are not capital expenditures. Case law has yielded inconsistent results on the question of whether wallpaper and carpet give rise to capital expenditures.
One commenter has suggested that the cost of even movable items such as garden hoses and lawnmowers can be added to the basis of a home if they are to be left with the home when it is sold. This logic would presumably extend to furniture which is attached to a wall, sprinklers, pool equipment, and outdoor furniture as well, provided that these items are to convey with the house.
In summary, installing a new component will tend to give rise to a capital expenditure, while fixing an existing component will tend to be a ‘‘repair.’’ However, a major repair to a system or appliance which substantially extends its useful life gives rise to a capital expenditure (for example, replacing the compressor of an old refrigerator should generate a capital expenditure). It is important to remember that every expense associated with remodeling or renovation is a capital expenditure. Since so many common home improvements are capital expenditures which add to a homeowner's tax basis in his house, a homeowner should keep extensive records, including receipts, for all home improvements which may be capital expenditures.
In translating this confusing body of law to loss-on-sale programs, company policy will come into play. Many companies do not consider improvements at all in calculating a transferee’s loss on sale, limiting the calculation to sale price less purchase price plus purchase closing costs. Others do consider improvements, but impose limits on the types or costs of improvements they will consider. For example, it is not uncommon for companies to ignore “life-style” types of improvements such as swimming pools, or to limit improvements they will consider to major items costing above some limit. Some companies will limit improvements taken into account to those within some time frame such as three years prior to the sale.
Regardless of company policy, however, if any improvements are considered in calculating loss-on-sale, the company should have in place procedures that require substantiation of the type of improvement and its cost. This dynamic alone causes some companies to ignore improvements in their loss-on-sale program.
To summarize, the determination of whether any type of work on a home is a “capital expenditure” or a “repair” is complicated, but crucial in those company loss-on-sale programs that include improvements in calculating the loss-on-sale. Company policy should be explicit as to what the company will consider, and how the transferee is required to substantiate those costs.
Posted by Peter K. Scott
The United States Supreme Court on June 28, 2012, upheld most parts of the 2010 healthcare law. Although not the focus of the litigation, the healthcare law included two new Medicare taxes on high income individuals, which will now go into effect as scheduled on January 1, 2013, unless Congress acts to repeal or modify them before then. Employers and individuals subject to these taxes should begin preparing for their implementation as soon as possible.
The Full Story:
The healthcare law imposes two new Medicare taxes on high income individuals, both of which take effect on January 1, 2013. Together, the taxes are estimated to raise over $300 billion over the ten years following 2012.
First, there is an extra .9% added to the existing 1.45% employee share of Medicare tax, for a total of 2.35%, for taxpayers whose wages exceed $200,000 ($250,000 in the case of married taxpayers filing joint returns). The employer’s share is not affected, remaining at 1.45%. The additional .9% employee tax is only applied to the portion of wages that exceeds the $200,000 or $250,000 thresholds. This additional tax will also be applied to self-employed individuals whose self-employment income exceeds the thresholds.
Although the new tax applies to combined wages exceeding $250,000 for married couples, employers are required to withhold the extra tax only if the employee working for the employer has wages exceeding $200,000. That is, the employer is not required to determine if combined wages will exceed the threshold. For example, if the employee has wages of $150,000, the employer is not required to withhold the extra Medicare tax, even though the employee’s spouse has wages of $150,000 from a different employer and their combined wages exceed $250,000. The employee and spouse will have to pay the extra Medicare tax with their income tax return. However, the provision will undoubtedly require some extra withholding for high income transferees, many of whom will exceed the $200,000 threshold only because of taxable relocation expenses. Companies will have to decide whether to include this extra tax in their gross-up policies.
Second, for the first time there will be a Medicare tax that applies to unearned income, in addition to wages. The tax is 3.8%, and applies to taxpayers with Adjusted Gross Income exceeding $200,000 ($250,000 in the case of married taxpayers filing joint returns). (Note the different measurement from the extra .9% Medicare tax above, which applies to those with wages exceeding the threshold). Unearned income (referred to as “net investment income” in the law) includes such items as interest, dividends, annuities, royalties, and rents, plus the taxable portion of net capital gains on sale of non-business property.
The tax applies to the lesser of unearned income or the amount by which the taxpayer’s Adjusted Gross Income exceeds the threshold above. Consequently, if a taxpayer has $100,000 of unearned income, but AGI of $220,000, the tax would apply to $20,000. There is no withholding obligation for payers of unearned income; the tax will be collected as part of the taxpayer’s income tax filing. However, employers relocating high income transferees will need to consider whether to gross up when taxable relocation expenses contribute to the transferee becoming liable for the tax.
The unearned income tax has prompted some concerns that it might affect relocation home sales, in part due to erroneous information that circulated on the internet that characterized the tax as a new tax on real estate. The tax is not a tax on real estate; rather, it is a tax that may apply to the taxable portion of gain from the sale of real estate.
Capital gain from sale of non-business assets, such as homes, is subject to the tax. However, the tax only applies to gain that is not otherwise excluded, so it applies after the current home sale capital gain exclusion is taken into account ($250,000 single, $500,000 married filing jointly). Further, the tax applies to gain, not to proceeds. So it is an issue only if, after subtracting the transferee’s basis in the home from gross proceeds, and then excluding gain up to the applicable home sale exclusion, there remains taxable gain.
For example, if a married couple sells their principal residence for $800,000, in which they have a basis of $400,000, the gain is $400,000, all of which is excluded from tax by the capital gain home sale exclusion, and the new Medicare tax will not apply. It is rare for relocation home sales to result in taxable capital gains. However, if such a circumstance occurs, the unearned income Medicare tax is then computed as above, on the lesser of the unearned income or the excess of AGI over the applicable threshold. If the couple in the example above sold the home for $1 million, there would be taxable gain of $100,000. If that couple had Adjusted Gross Income (including the home sale gain) of $300,000, the new 3.8% tax would apply to $50,000 (the lesser of the unearned income of $100,000 or the amount by which AGI exceeds the $250,000 threshold). Tax would be $1,900.
As the foregoing illustrates, it is unlikely that the new tax will apply to more than a very few relocation home sales, or that it will result in substantial tax liability even in those cases. However, it could have an impact on sales of second homes or other real estate, for which there is no capital gain exclusion.
As with the extra .9% Medicare tax on wages, the tax will affect transferees who are over the AGI threshold, either independently or as a result of taxable relocation benefits, and companies will need to consider whether to adjust their gross-up policies. For example, if a single transferee has unearned income of $20,000, AGI without taxable relocation benefits of $190,000, and taxable relocation benefits of $25,000, he or she will be exposed to the new 3.8% tax on $15,000 of the unearned income as a result of adding the taxable relocation to AGI. The additional tax is $570. Unfortunately, as with other issues such as the loss of credits which phase out at certain income levels, it will usually not be possible to determine at the time of payment of relocation benefits whether they will affect liability for the 3.8% tax.
Worldwide ERC® members should take steps to integrate these new taxes into their payroll and gross-up systems quickly, as it now appears that they will certainly go into effect as scheduled unless Congress acts after the November elections to repeal or modify them.
Posted by Peter K. Scott
The regulation of appraisal management companies continues to be a hot issue in many state legislatures. The legislation currently being considered by legislatures would primarily set standards for the registration and oversight of appraisal management companies. These bills would also provide a template for the setting of registration and renewal fees. Although some state legislatures have taken the fee issue further by looking at also requiring surety bonds. In most cases, relocation management companies are excluded from the standards and paying the fees.
A majority of the legislation that has been either recently enacted or is still pending is based on the Appraisal Management Company Registration & Regulation Model Act developed by the Appraisal Institute. For a copy of the Act, please go to the document found on the Appraisal Institute website at: http://www.appraisalinstitute.org/newsadvocacy/downloads/StateIssues/Model_Provisions_for_AMCs_11_4_10.doc. Below is a sampling of legislation being considered by state legislatures to regulate and/or set registration fees for appraisal management companies.
The Kansas Appraisal Management Company Registration Act (SB 345) was introduced in the Kansas Senate on January 26 and referred to the Senate Committee on Federal and State Affairs. The Senate Committee on Federal and State Affairs amended and passed SB 345 on February 13. The bill passed the Senate on February 23 by 40 to 0 and was received and introduced in the Kansas House. On March 21, the House passed the bill 115 to 9 and on March 30 it was presented to the Governor. The legislation would not apply to relocation management companies.
The Kansas Appraisal Management Company Registration Act was drafted and approved by the Kansas Real Estate Appraisal Board. The legislation would institute a process for the registration and regulation of companies that provide real estate appraisal management services. It would direct the Kansas Real Estate Appraisal Board to establish a registration fee for appraisal management companies. The registration fee could be no more than $3,500.
For the most recent copy of SB 345, go to: http://www.kslegislature.org/li/b2011_12/measures/sb345/. For a copy of the final draft by the Kansas Appraisal Management Company Registration Act, go to: http://www.kansas.gov/kreab/pdf/AMC%20legislation%20FINAL.pdf.
SB 2903 would permit the Mississippi Real Estate Commission to charge real estate appraisal companies a registration and renewal fee up to $1,500. It would also require a real estate appraisal company to submit with its registration application a surety bond of $50,000. SB 2903 passed the Senate on March 14 and on March 19 was referred to the House Committee on Ways and Means. On March 29, SB 2903 passed as amended. A similar House bill, HB 1286, died in the Ways and Means Committee on March 6. It is unclear at the time of this posting as to whether SB 2903 would apply to relocation management companies.
The Appraisal Management Company Registration Act (A 1756) was introduced in the New Jersey Assembly on January 10, 2012 and referred to the Regulated Professions Committee. It would set a registration and processing fee for appraisal management companies at no more than $500 each. Relocation management companies would not have to register or pay a processing fee under the legislation.
The temporary administrative rules regarding registration and application fees remain in effect until June 27, 2012. The fee varies depending on the number of appraisals performed by the appraisal management company. The temporary rules do not apply to relocation management companies.
A business entity that has not previously conducted business in Oregon, a business entity performing appraisal management services for under 250 instances of real estate appraisal activity in Oregon in the previous calendar year, or a business entity otherwise serving as a third-party broker of real estate appraisal activity for under 250 instances of real estate appraisal activity in Oregon in the previous calendar year, shall pay to the Board:
a)A nonrefundable application fee of $250;
b)A nonrefundable registration fee of $500.
A business entity performing appraisal management services for 250 to 1,000 instances of real estate appraisal activity in Oregon in the previous calendar year, shall pay to the Board:
a)A nonrefundable application fee of $1,000;
b)A nonrefundable registration fee of $1,500.
A business entity performing appraisal management services for 1,000 to 5,000 instances of real estate appraisal activity in Oregon in the previous calendar year, shall pay to the Board:
a)A nonrefundable application fee of $1,500;
b)A nonrefundable registration fee of $3,500.
A business entity performing appraisal management services for 1,000 to 5,000 instances of real estate appraisal activity in Oregon in the previous calendar year, shall pay to the Board:
a)A nonrefundable application fee of $2,000;
b)A nonrefundable registration fee of $6,000.
To access a copy of the temporary regulations, please go to: http://oregonaclb.org/aclb_prod/images/stories/pdf/temprulesamc.pdf
The Appraisal Management Company Registration Act (H 398) was approved by the Governor on February 2. The Pennsylvania Senate had passed H 398 by a vote of 50 to 0 on January 18 and the State House of Representatives by 190 to 4 on January 23. H 398 requires the registration of appraisal management companies with a fee of $1,000 per registration or registration renewal. The new law does not apply to relocation management companies.
For a copy of the most recent version of the Appraisal Management Company Registration Act, go to: http://www.legis.state.pa.us/cfdocs/billinfo/billinfo.cfm?syear=2011&sind=0&body=H&type=B&bn=398
The Appraisal Management Companies Act (H 3717) was introduced in the South Carolina House of Representatives on February 22, 2011 and referred to the House Committee on Labor Commerce and Industry. H 3717 would establish the South Carolina Real Estate Appraisal Management Services Board to regulate real estate appraisal management companies. H 3717 would not apply to relocation management companies.
Posted by Tristan North
US real estate is doing poorly; everyone knows that; and it is not getting any better according to the latest statistics announced this week. Fortunately the demographics of relocating employees tend to shield them from the worst aspects of the market, but of course they are also negatively affected. In this market, pre decision counseling certainly makes sense.
The Foreign Corrupt Practices Act has always presented lawyers and compliance personnel with a difficult target because so many investigations under it are settled before courts can rule on its reach and scope. It looks like the Department of Justice will provide some guidance regarding its interpretation of the law in 2012, 23 years after Congress asked it to do so.
The Rest of the Story:
US Real Estate.
Nationally, US median home prices continued their downward trend in over 75% of metropolitan markets, according to a just released study by the National Association of REALTORS®.
The third quarter results, however, do show an increase in prices in 39 of the 150 MSAs studied. Last quarter, 41 metropolitan areas posted an average gain, according to NAR’s calculations.
Looking at the effect of the sale of distressed properties, according to CoreLogic single-family home prices declined nationally 4.1% from a year earlier and 1.1% excluding distressed sales. Overall, home prices in September were down 31.2 percent from peak levels in April 2006 and 21.9% excluding distressed sales. The national delinquency rate for borrowers 60 days or more past due on their mortgages increased during the third quarter for the first time since 2009, according to the credit reporting agency TransUnion.
The largest price declines were in Mobile, Ala. (-17.7%), Phoenix, Ariz. (-17.6%), Allentown, Pa. (-17.5%) and Salt Lake City (-15.3%). Price increases were found in Grand Rapids, Mich. (23.7%), South Bend, Ind. (19.8%), Palm Bay-Melbourne, Fla. (17.7%) and Youngstown, Oh. (13.1%).
Adding all of the changes over the whole country, the median national home price fell from $177,800 in the third quarter to $169, 500 last quarter, a 4.7% decrease, according to NAR.
Not surprisingly, home sales also fell to an annual rate of 4.88 million, a slight decrease from the second quarter, but a significant gain from the 4.17 million a year ago. Forty five states and the District of Columbia posted double digit gains in sales over the past year, showing that the easing in prices is likely the result of distressed sales. NAR estimates that fully 30% of sales consists of those properties.
Interestingly, the number of mortgage modifications arranged under HAMP (the Home Affordable Modification Program, a federal program run by HUD) increased significantly to over 40,000 – an increase of about 50% from the previous month, and those arranged under the HARP (Home Affordable Refinance Program, another federal program applicable only to mortgages guaranteed by Freddie Mac or Fannie Mae) increased slightly.
Neither of these mortgage modification programs has been particularly successful over the past two years in helping refinance the estimated 1 million plus houses that are now in distress, i.e. that have mortgage payments over 30 days in arrears. To try to combat this trend and increase modifications for those who still have jobs, the Administration and the FHFA just announced a plan to revamp these programs to try to decrease the paperwork and administrative burden that have been accused as a primary cause of the small number of modifications that have occurred – about 800,000 out of as many as 2 to 3 million that may qualify. The administrative changes will likely consist of lowering the loan to value ration required for the refinance and perhaps eliminating the need for a full appraisal on the property. In addition, the requirements regarding missed payments may be relaxed; in any case it is estimated that these changes will only increase the number of eligible participants from 3% to 5%. Helpful, but not the silver bullet for the housing market.
How bad is the overhang of available properties related to current demand? Freddie Mac’s third quarter report gives an idea. During that period the GSEs sold 25,300 repossessed houses, a slight decrease from the previous month. They repossessed an additional 24,300 houses, however, during that period; thus the bad news is that based on these figures, it is estimated that it would take the GSEs about 15 years to unload their existing inventory.
According to the latest estimates, it takes 761 days to complete a foreclosure in a judicial foreclosure state, and 580 days in nonjudicial states. This time lag will have two effects on the recovery; on one hand it will help smooth the effect on market absorption of the foreclosed properties, thus helping ease price fluctuations, on the other hand it will probably lengthen the recovery as foreclosures continue to come on to the market years after the mortgage fell delinquent. With the federal settlement (still in the works, apparently) regarding robosigning, and the state actions such as the recent Nevada law banning foreclosures with any robosigned documents, foreclosures will continue to play a part in the housing market for at least several more years.
Of course, when the market picks up, the delta will likely decrease, lowering the time it takes to unload the repossessed properties. But it will certainly take some time as the market rises, which points to a slow recovery in the housing market, whenever it comes.
In the meantime, the rental market – made up primarily of multifamily units, has seen a steady increase as demand increases from displaced homeowners. About 1.4 million families moved into rentals over the past year alone. Renters now make up more than 40 million households, nearly one third of all US households. This increase in demand is beginning to cause upward pressure on rents in many areas, and will likely spur a significant building boom in the near future.
What do these figures portend for the employee mobility industry? Not much change, actually. The housing market continues to hug the bottom, driven by the huge shadow inventory of distressed housing and the increased underwriting standards that are slowing down both purchases and sales.
Fortunately the relocation housing market tends to concentrate in the higher income urban and semi urban areas that are faring better than the averages. This market tends to be better in terms of selling period (days on market) and price diminution. That being said, even in these markets there is certainly nothing like recovery to the pre-bubble markets, and there will likely not be so for several years. More transferees will likely be looking at short sales an or rentals, both on the destinations and departure sides of their moves, and this will require counseling. Pre decision counseling by the employer or RMC should become a part of the homesale process at least until the housing market clears up.
FCPA Guidance? As the employee mobility industry globalizes, the need for understanding of and compliance with the Foreign Corrupt Practices Act (FCPA) has become critical. Even those companies that do not actual provide services over national borders can be affected, either through contracting with foreign companies, or through the compliance activities of their customers. I have written on the FCPA and its reach in our industry, and it continues to be good advice for all companies to understand what if any interface they have with this anti-bribery and record keeping law.
One difficult fact about the FCPA is that while there have been many prosecutions, fines and jail sentences handed out as a result of recent DOJ and SEC investigations, there are many grey areas of the law that make compliance difficult. Usually unsettled areas of criminal laws are settled by court cases, and lawyers and compliance personnel can review the facts in those cases to find the areas of the law-fact interface that the prosecutors and courts believe are prohibited.
Unfortunately, many current FCPA cases are quickly settled after the DOJ or SEC begins to investigate allegations-- or even suspicions -- of wrongdoing. These settlements most often result in large fines and agreements to beef up compliance mechanisms. Sometimes, the prosecutors simply dragnet an industry because of allegations against a single company. Settlement is often a good choice because of the millions of dollars it requires to defend a large case, and win or lose, the reputational damage a company is likely to suffer.
Because of this uncertainty and lack of understanding of the reach of the law, the US Chamber of Commerce has been lobbying Congress to modify it for clarity. Interestingly, a 1988 amendment to the law ordered the DOJ to provide some guidance regarding it. Recently the UK Justice Minister provided guiding principles for the application of the UK Bribery Act; the law did not take effect until they were issued. The FCPA was adopted in 1977 and has been enforced since then in accordance with the changing philosophies of the prosecutors.
There may be some help on the way. Yesterday, the Assistant Attorney General announced at a conference that the Justice Department is working on guidance to be released next year. When this occurs it will be good news for compliance personnel, allowing them to fine tune their programs to the interpretations of the prosecutors.
Backdated to cover transactions occurring after August 1, 2007, the New Jersey Bulk Sales Act has been modified to exclude some home sales from its reporting requirements. Basically, the modifications exempt private individuals and some trusts and estates from the its requirements, and excludes seasonal rental property (as contrasted with primary residences) from the necessity to give prior notice to the Division of Taxation of a house sale. The exemption does not include sales by business entities, however, and a typical relocation home sale will benefit by having the first sale exempted, saving time and reducing liability for the employee’s unpaid state taxes. The sale to the ultimate purchaser, however, is not exempted in most cases.
The Full Story:
Lawyers are familiar with “bulk sales acts” which are state laws that prescribe a method whereby a business can sell all or substantially all of its inventory or assets to buyers – usually in the process of going out of businesses. Bulk sales laws most often require the seller to file notifications to creditors (and often the state), and after a period if there is no objection, the inventory or assets are sold free of liens. The idea is to protect the creditors of the business from having assets sold out from under their liens and to protect buyers from later claims that the goods they purchased are subject to prior claims, and to notify the state so that it can collect any unpaid taxes from the proceeds. In just about every state these laws do not apply to residential real estate. But they do in New Jersey, and this can affect home sale programs with properties in that state.
The New Jersey Sales and Use Tax Act (NJSA 54:32B-1 et seq.) has been in effect since 2007; since that date, the New Jersey Division of Taxation has had the authority to apply the Act to residential real estate sales where the property has been used in conjunction with a trade or business. Covered properties cannot be sold free and clear without the required bulk sales notice given to the Division at least 10 days prior to the closing. Failure to do so may subject the buyer to liability for any unpaid taxes owed by the seller.
Changes to the statute effective retroactively to August 1, 2011, however, ameliorate the application of the regulations somewhat. Those changes added a new section (2) to section 5 of P.L.2007, c.100 (C.54:50-38) exempt single family dwellings if the seller (or assignor) is an individual, estate, or trust as defined by the N.J. tax laws. If will still apply to the sale if the transformer or assignor is a business entity. Also exempted are certain “seasonal rental properties”, and the coverage applies to condominiums as well as timeshares. No changes have yet been made to the regulations, but the New Jersey Association of REALTORS, which was primarily responsible for lobbying these changes, has published a revision of its contract form reflecting the modification to the statute. Because the law backdates its provisions to 2007, it effectively removes any previous as well as current liability of buyers for sellers' back taxes.
As a refresher, the mechanics of following the bulk sales requirements (where the seller or property is not exempted) are not difficult, but are time-consuming. The owner (seller) of a covered property must file and deliver to the buyer a Purchase and Asset Transfer Tax Declaration form (form TTD); the buyer must then prepare and deliver to the Division of Taxation the form TTD it received from the seller, a Notification of Sale, Transfer or Assignment in Bulk (form C-9600) which it fills out, and a copy of the fully executed purchase agreement. This must be received by the Division at least ten days before the closing date. If no taxes are owed by the seller to New Jersey, the Department issues a Letter of Clearance, and the settlement can proceed as usual. If taxes are owed, an escrow must be set up and funded from the proceeds of the sale; these funds can only be released when all tax liability is released by the Department. It is only at this point that the buyer is free from any liability for the seller’s unpaid taxes.
The effect on the employee mobility industry of these just passed exemptions is helpful. It means that the sale of a property by the employee to the employer or relocation management company (RMC) is not subject to the delay of the bulk sales notification, and it consequently relieves the employer or RMC of any potential liability arising out of unpaid state taxes owed by the employee. This is a good thing. It does not, however, exempt the sale by the employer or RMC to the ultimate purchaser, since it specifically makes the reporting requirements applicable to sales by “business entities”. However, by eliminating the delay and potential liability from the first sale, the changes to the Bulk Sales Act should be very helpful in speeding up New Jersey home sales.
Posted by Dick Mansfield
It has been about two years since some houses, mostly in the Southeastern US began to show signs of internal corrosion on copper and silver electrical and air conditioning materials. It did not take long to uncover the source: defective drywall imported from China and labeled by a German company, Knauf. Because of impurities in the gypsum incorporated into the finished drywall, an increased amount of sulfur and other gasses are released over time, likely because of heat or humidity. While almost all drywall, from whatever source, emits some gas over time, the imported Chinese drywall has proven, in some cases, to emit a significantly larger amount.
The sulfur based gasses emitted by defective Chinese drywall cause several detrimental issues. First, they can fill the house with a “rotten egg” odor. Second, and far more importantly, they are slightly corrosive to metals, especially copper. Over time, the corrosion can cause short circuits in electrical wiring and machinery, and can render air conditioning coils inoperative by weakening them so that they cannot contain the pressurized refrigerant.
Fixing the problem is unfortunately not cheap, since the interior of houses is covered with drywall, and once painted, it is difficult if not impossible to check the lot numbers and manufacturers’ names which are generally printed on the face of each sheet of drywall. To add to the difficulty, not all imported drywall, even if from the same manufacturer, contains gypsum that significantly off gasses. Therefore, the only sure way to stop the damage from the contaminants is to strip and replace all of the drywall in a house, and to replace any wiring or machinery that shows signs of corrosion. The cost of doing this can be in the tens or hundreds of thousands of dollars. In the depressed housing market, it can exceed the market value of the house itself.
As occurs in just about all defective products cases, a class action suit was filed on behalf of homeowners While some owners had filed individual suits in the jurisdictions where they live, it is likely that this class action, which was a consolidation of other federal court cases in the federal district court in New Orleans (In Re: Chinese Manufactured Drywall Products Liability Litigation) will cover many, if not most defective drywall houses, and will set precedent for future cases where the owner may have opted out of this litigation. As of last month, over 10.000 owners have joined the class.
As is usual in defective products litigation, the plaintiffs’ tactics were to sue the manufacturer, suppliers, distributors, and builders on product liability claims, and to sue the insurers that refused to pay for remediation under homeowners’ policies. In December, the trial judge ruled that the “corrosion” and “faulty materials” exclusions found in most of these policies apply to the Chinese drywall litigation, and dismissed these claims against the insurance companies. While this ruling, which was made in a preliminary motion in the case, is not dispositive in other cases, and is indeed subject to appeal at the conclusion of this case, it is unlikely that other federal courts will rule differently in the future. There have been sporadic state cases that have ruled differently, though; but none has gone to appeal, and again, it is unlikely that the carefully written exclusions that were adjudicated in New Orleans will be held invalid.
With the insurance companies out of the class action case, the plaintiffs continue to look to the other parties for recovery. Late last year, Kanuf agreed to remediate 300 houses as a demonstration project and a means of determining the extent and cost of the removal of defective drywall; this project was part of settlement discussions, and the first house was completed in February. In it, drywall, electrical, HVAC and affected appliances were replaced. The fact that Knauf agreed to complete this demonstration, however, does not in any way signal that it is amenable to including the thousands of other houses that form the basis of the suit.
While the class action suit is continuing, the federal government has published its views on remediation. In March, the Consumer Products Safety Commission (CPSC) and the Department of Housing and Urban Development (HUD) issued their updated remediation protocol for houses with defective drywall. What was new in this report is a recommendation that the electrical wiring in an affected house need not be replaced. Now, these agencies recommend that remediation remove all problem drywall, fire safety alarm devices, electrical distribution components, including receptacles, switches and circuit breakers, and gas service piping and fire suppression sprinkler systems.
Interestingly, the federal trial judge disagreed with the revised protocol because of technical problems in replacing electrical components without replacing the wiring.
While the case is winding its way through the judicial process, several companies, mostly distributors, have reached settlement agreements with the plaintiffs. For the most part, these companies were reimbursed by their insurance companies (not under homeowners’ policies, but under commercial insurance contracts). In April, a New Orleans building products supplier, Interior/Exterior (Inex) settled for $8M, its policy limits on one policy, and assigned its claim for an additional $72M under another policy. A second company, Banner Supply has reached a settlement agreement for $55M, which is pending for the judge’s approval.
Since the damages in this case, which might be the largest products liability case involving defective construction materials in US history, will be many times the settlements collected to date, the discovery state is continuing with the plaintiffs searching for more “deep pockets”. The case will likely take years, leaving most owners stuck with houses that are practically unsalable, and in some cases unlivable.
The bottom line for the employee mobility industry remains the same: these houses should be excluded from home sale programs if at all possible. Special programs or exceptions can be used to dispose of them, but inclusion into a general AVO or BVO program is risky at best, for several reasons. First, a house with disclosed Chinese drywall is most likely salable only at a very severe discount from competing properties. Second, even if a BVO buyer is willing to make an acceptable offer, and if the employer is willing to accept (and amend), it is still important to get releases from the buyer based on real and complete disclosure. Even though there is no evidence of any detrimental health effects caused directly by Chinese drywall, releases must cover any known or unknown health issues, and local counsel should be involved since it is not possible in some jurisdictions to enforce a release for as yet unknown liabilities. The release process adds risk and costs to the sale.
It is possible that a house with Chinese drywall is inadvertently taken into a relocation program, which presents quite a dilemma. If the drywall is discovered before the sale of the house to the employer, most contracts contain a clause that allows the contract to be cancelled upon discovery of significant construction defects. At this point, the employer can decide on how to handle the property. Sometimes, however, the drywall is discovered only after the employer’s purchase, and, even more difficult, after the third party buyer closes. Fortunately, there have been no reported cases where this has happened, but that may be because of the poor housing market in those areas where Chinese drywall was used during the years 2004 to 2006. In such a case, it is likely that proper disclosure normally given by the employer or relocation management company will forestall any liability, but because of the cost to remediate, buyers are likely to sue anyway.
The best advice is still to have in place an active discovery process: ask the transferee, scrutinize houses in southern and southeastern states and that were built, rebuilt, or remodeled in the 2004 to 2006 time period, and if necessary, have suspected houses inspected. Once the drywall is identified by any method, then the employer can decide how to handle the relocation.
It will take years before the class action suit will end, and even then, there is not a strong likelihood that all remediation costs will be covered as a result.
In this blog, I will give an update on three issues that are affecting – or that might affect—domestic home sale programs: the ongoing fight over QRM (Qualified residential Mortgage) regulation and the broad reach of the New Jersey Bulk Sales Act.
Dispute I have discussed the QRM issue previously, but it is useful to keep the facts and implications at the top of mind. This time last year, the concept of a QRM did not exist in the law; it was introduced in the 2000 plus page Dodd-Frank (Wall Street Reform and Consumer Financial Protection) Act. That Act fundamentally changed the mortgage business, and, among other requirements, mandated that banks and other securitizers of mortgages retain five percent of the value of the loan on their books, as a form of risk retention. The idea is that mortgagees will be much more careful in their underwriting if they have some “skin in the game”, i.e., if they have a financial interest in the health of the mortgage going forward. Thus there will be two basic mortgage types available after the rules (that are currently being debated) are adopted by the Federal Reserve.
Interestingly, the FHA and VA government backed loans are exempt from these requirements. And the proposed regulations will also exempt the GSEs from the requirements. However, as the federal government continues to pour money into the otherwise insolvent Freddy Mac and Fanny Mae are not likely to continue to remain structured as they are currently, so this is at best a short term fix which will not stem the long term problem. Eventually the private mortgage security market must again flourish (albeit in a more safe and effective form) if the real estate market is to recover in the US.
The issue with non-QRM loans is that only the largest banks can afford to keep the five percent retention; in the banking world the amounts retained will diminish the amount the bank can lend, thus allowing only the largest and most well capitalized to issue these loans, and even then at greater cost. One estimate, though speculative, is that non QRM loans may add as much as three points to the cost of the loan; whatever the number, they will almost surely be significantly more expensive because of the opportunity costs faced by securitizers that must hold back the required reserve.
But the biggest objection lies in the definition of a QRM. The Act describes the characteristics necessary for a loan to qualify as a QRM, the two relevant to this discussion are the need for strict underwriting to ensure the creditworthiness of the buyer, and the need for a down payment, thus keeping the loan to value ratio low so as to ensure the value of the collateral covers the loan balance.
No one disputes the need for good solid underwriting of mortgages. Of all of the causes of the 2008 housing collapse, poor underwriting is probably at the very root of the debacle. There are proposed regulations regarding some underwriting requirements – especially the debt to income ratios -- that are onerous and are not economically necessary; however, those regulations are not as imminent and will be dealt with after the most glaring and onerous requirement: the large down payment requirement.
The proposed regulations require a 20% down payment for a QRM, a requirement that is supposed to make the loan safer for the issuer, and this must be combined with sound underwriting practices. Unfortunately, the hard cold facts do not justify this conclusion; in fact, the CoreLogic statistics discussed in the whitepaper I will examine below show that it is underwriting, not size of down payment, that determines whether a loan is likely to go sour. Unfortunately, the current proposed regulations require a 20% down payment for a QM loan, and 25% equity for a QRM refinancing.
This high down payment will force a large number of borrowers into the more expensive non QRM market, and the higher interest will disqualify many of these potential buyers; the rest will end up paying much higher costs. Because of this, the effects of these regulations will likely adversely impact on all segments of the home buying population.
An unusual coalition, led by housing related trade associations (notably the NAR and MBA) along with forty other groups have formed a coalition to inform the regulators and the Congress of the potentially devastating effect the rules – especially the down payment rules—will have on the fragile and slowly recovering real estate market. And because of the widespread affect these regulations could have, many groups representing low and moderate income consumers have joined the coalition because they, too see that their constituencies will be adversely affected. Worldwide ERC has also joined, and is providing our expertise and perspective from the employee mobility perspective.
As a quick summary, the whitepaper concludes:
“The proposed QRM rule is narrowly drawn, producing a requirement that is misaligned with three key pillars of Congressional intent:
For consumers, the QRM was intended to provide creditworthy borrowers access to well underwritten products. Although Congress intended for QRMs to be broadly available, the regulators acknowledge that they crafted this rule to make the QRM “a very narrow slice” of the market.
Despite specific Congressional rejection of down-payment requirements in the QRM legislative provisions, a fact attested to by the QRM sponsors, the regulators have insisted upon a punitive down payment requirement, even when confronted with ample historical loan performance data that shows down payment is not a primary driver of a loan’s performance provided the loan has been properly underwritten and has consumer-friendly features.
For the housing market, the statutory intent of the QRM was to provide a framework for responsible liquidity provided by private capital that would be broadly available to support a housing recovery. However, the QRM definition in the proposed rule is so narrow that the vast majority of both first-time and existing homeowners will face potentially significantly higher interest rates, or have to postpone purchases and refinances.
For the structure of the housing finance market, the QRM was intended to help shrink the government presence in the market, restore competition and mitigate the potential for further consolidation of the market. Again, the proposed rule is likely to have the opposite impact."
It is for this reason that such a varied group, including Worldwide ERC, has joined to inform the Congress and regulators of the unintended consequences of the regulations as they have been proposed.
New Jersey Bulk Sales Act
Lawyers are familiar with “bulk sales acts” which are state laws that prescribe a method whereby a business can sell all of substantially all of its inventory or assets to buyers – usually in the process of going out of businesses. Bulk sales laws most often require the seller to file notifications to creditors (and often the state), and after a period if there is no objection, the inventory or assets are sold free of liens. The idea is to protect the creditors of the business from having assets sold out from under their liens and to protect buyers from later claims that the goods they purchased are subject to prior claims. In most cases these laws do not apply to residential real estate.
But they do in New Jersey, and this can affect home sale purchases in that state.
Since 2007, the New Jersey Sales and Use Tax Act (NJSA 54:32B-1 et seq.), the New Jersey Division of Taxation has had the authority to apply the Act to residential real estate sales where the property has been used in conjunction with a trade or business. Covered properties cannot be sold free and clear without the required bulk sales notice given to the Division at least 10 days prior to the closing. Failure to do so may subject the buyer to liability for any unpaid taxes owed by the seller.
From the legal perspective, the operative language lies in the regulations promulgated by the Division of Taxation, which define “business assets” subject to the Act as (among other categories): “…realty if a use of the realty is to support a business on its premises which includes, but is not limited to, renting space to another.” In the relocation context, the breadth of this definition would include primary residences that were temporarily rented, instead of sold, during a relocation; residences in which an occupant such as a spouse conducted a home based business; and in fact, any residence which, as the regulations state, “support” a business on its premises.
The mechanics are not difficult, but are time consuming. The owner (seller) of a covered property must file and deliver to the buyer a Purchase and Asset Transfer Tax Declaration form (form TTD); the buyer must then prepare and deliver to the Division of Taxation the form TTD it received from the seller, a Notification of Sale, Transfer or Assignment in Bulk (form C-9600) which it fills out, and a copy of the fully executed purchase agreement. This must be received by the Division at least ten days before the closing date. If no taxes are owed by the seller to New Jersey, the Department issues a Letter of Clearance, and the settlement can proceed as usual. If taxes are owed, an escrow must be set up and funded from the proceeds of the sale; these funds can only be released when all tax liability is released by the Department. It is only at this point that the buyer is free from any liability for the seller’s unpaid taxes.
Needless to say, this significant increase in paperwork, along with the potential liability of the buyer, as slowed down New Jersey sales; it is especially noticeable in all two sale transactions, because there must be at least a ten day wait to close on covered properties in order to make certain that there is no hold up in the transaction, and no residual buyer liability.
There are some steps that are necessary to make New Jersey relocation sales smoother and cleaner, but the ten day time delay is inevitable. Here are some tips:
First, try to identify properties that have been overtly used in connection with a business (rental, home business, etc.), so that the proper form can be prepared in advance, and provided to the closing attorney and the buyer.
Second, make certain the contract has provisions reflecting the requirements of the law: i) that the buyer and seller will comply with the Act, ii) that the buyer may file the proper forms 10 days before settlement, and that any state required escrow will be held until the obligation to the state is released, and iii) the seller indemnifies the buyer for its tax obligations under the sale.
Needless to say, this requirement certainly ads to the necessity of having counsel involved in the sale process sooner rather than later.
This process is only required for real estate located in New Jersey, and hopefully no other state will adopt such a broad definition of bulk sale assets.
Some companies will allow transferees to enter a BVO program with a short sale, others will not. If, as I suspect, banks refine and speed up the process, it is likely that more employees will become eligible. This is a good thing in so far as it may reduce reluctance to move, and it may reduce the need for other financial incentives now paid by employers in order to incent the employee to move.
Here is a brief checklist of issues that must be dealt with in a short sale. It is not exhaustive, in that many state and local issues may also be involved. And each lender has its own requirements. However, these issues should touch on most of the items that distinguish a short sale from a regular sale.
A much more thorough and practical discussion written by Bruce Perlman, Senior Vice President and General Counsel at CARTUS will appear in the July edition of Mobility.
Where the transferee is the seller (departure side of the relocation):
- Open negotiations with lender (probably the servicer is the best place to start); use of a broker or licensed short sale negotiator is often advantageous. Here one finds out the lender’s policies, and hopefully receives the initial short sale letter listing the necessary paperwork. It is important to scrutinize any initial paperwork for the terms, and especially to be on the lookout for claw back or other terms which might make the sale conditional on post closing lender acceptance of documents. Few purchasers will accept these conditions, and they are absolutely a problem in a two sale relocation policy.
- One question that often arises is the effect of a short sale on the sellers’ credit. Unfortunately, it is not an easy one to answer precisely, but it is universally true that there is most often a very serious negative effect, perhaps as much as a 50 – 200 point deduction from the presale FICO score (the higher the original score, the more the deduction). And generally short sales, like bankruptcies, remain on the credit report for seven years. It may be possible to negotiate with the bank to have it provide “paid in full” credit reporting on the transaction, depending on the circumstances. Another important tip is that short sale negotiations need not be started with the mortgage in a delinquent status, which would also adversely affects one’s credit score.
- Assemble the documentation. If a hardship letter is required (some banks require it before any other documentation, and will not agree to a sale without first approving it), one should be drafted, and will likely include the fact that the house is seriously underwater, that the seller does not have assets sufficient to pay the deficiency in a sale at the current time, and that the employee has been offered a job by the employer in another location. Appraisals, BMAs, or BPOs will be required early in the process, so the facts underlying the value of the house need be proven early on. If the traditional hardship factors are present, such as unemployment (of a spouse), illness, divorce, death in the family and the like, these make a more powerful argument for the short sale, as does bankruptcy.
- Most often lenders will require full financial disclosure from the seller, in order to prove that there are no hidden assets that could go to pay off the loan.
- It is absolutely important to fully and honestly disclose whatever information the bank requires, including the existence and amount of relocation benefits, and the fact that the house will be entered into a relocation transaction. Relocations still are strange to many lenders, and a careful explanation of the two sale process is critical. Remember that the laws regarding mortgage fraud are applicable to all aspects of the short sale.
- If the house will be sold in a BVO program, the bank will likely want to see both contracts.
- A rule of thumb in short sales is that there may be profit in these transactions, but none goes to the sellers. That being said, writing down of some part of the principal of an underwater house is a pretty good deal.
- Know the tax consequences of a short sale. Pete Scott has addressed this here:
Where the transferee is the buyer (destination side of the relocation):
- Understand that the process will take much more time than a normal sale.
- Be certain that there is a clause in the contract of sale that provides a time contingency for bank approval; this is important so as to protect any earnest money or escrow that is involved. Legally, the contract is not valid until the bank agrees (signs), but the time contingency provides protection to the buyer if the bank is unduly slow in its decision making (which could be based upon the buyer’s disclosures). Of course, make sure the proper contract is used; a regular sale contract is unacceptable since the bank must agree. In some cases buyers may use a standard contract as a negotiating tool with the bank, but this is not a good idea from a buyer’s point of view, and should be avoided, in my opinion.
- Purchaser’s title insurance is an absolute requirement to protect the buyer from any possibility of claw back based upon fraud or misrepresentation by the seller in the short sale process.
Five years ago, few knew what a short sale was, and fewer still remembered how they were done, or what the tax consequences of a sale were to the seller. The Great Recession reminded us all of the details of this hybrid transaction in which the bank (mortgagee) agrees to the sale of a house for less than the amount owed, forgiving the balance over the net sales price, and removing the first (purchase money) lien on the property thereby allowing the unencumbered sale of the property, and taking a loss on the loan.
Now short sales are becoming more common as other programs, such as federal and private mortgage modification programs flounder – mostly because unemployed or underemployed borrowers find themselves better off in foreclosure or short sale, than attempting to temporarily reduce their monthly payments. The exacerbating factor, of course, is that as many as 30% of all houses are worth less than their mortgage; it makes little sense to modify a mortgage, or even lower the principal if the loan is greater than, or even equal to, the current value of the property. With home prices continuing to fall in almost all markets, it makes even less sense.
Banks and servicers have been slow to warm up to short sales in many geographical areas. This is not surprising, since no financial institution can long survive if it consistently writes off investments from its balance sheet. A complicating factor in the current mortgage environment is that much of this paper has been bundled into CDOs (collateralized debt obligations) or other forms of securities, and releasing the mortgage for less than face value affects the value of the security. This does not make the investors happy.
(For convenience, I use the term “bank” or “lender” to cover all of the financial institutions that hold or service mortgages, in whatever form they may have been sold, securitized, or held as an asset. Even though CDOs were sold to investors, the entities which assembled the securities still have some obligation to the investors, as numerous lawsuits have underlined. )
However, as the banking industry struggles to fully recover from the Great Recession, the need to clean up balance sheets and to liquidate underperforming or nonperforming mortgages becomes more important. Traditionally, the former were considered candidates for loan modification, and the latter candidates for foreclosure. But with an estimated 1 million houses in, or eligible for foreclosure, banks face a new reality. The existence of this “shadow inventory” – houses not actively on the market but which will end up there soon, has changed the business calculus of foreclosure. In rising or stable markets, where a house value is not underwater and where the locality has a normal sale inventory, a bank could readily calculate the sale price of the house at foreclosure. They did not always recoup the mortgage principal, but they did have a good idea of how much they would lose.
Today’s environment, with the continuing loss in value of the housing inventory (see my blog of May 9 for a current scan of the market), and the large inventory overhang makes an educated prediction of foreclosure prices very difficult. When carrying and opportunity costs are figured into the net recovery, mortgage holders find that getting rid of the offending asset as quickly as reasonably possible is the least costly alternative. Thus the large scale foreclosures we saw in the latter part of last year – the process which turned into the “robo signing” fiasco for which banks are still being investigated.
At this point foreclosures are mostly back on track, though not at the level of last fall. Lenders are back into the process of disposing of their bad or underperforming loans. And it is likely that as this process continues over the next year or so (at least), the inventory will further depress house prices, causing even greater bank losses.
Short sales can yield the lender a greater net return on the nonperforming loan than foreclosures and REO sales. In my opinion, we will begin to see them become a greater part of distressed property sales in the near future, increasing to cover underperforming mortgages as the Great Depression pushes more unemployed and underemployed workers into financial distress and the value of their houses lower.
Short Sale Basics
Short sales are in essence controlled foreclosures in which all parties, the borrower, bank, and usually buyer, are better off than in a traditional foreclosure. The bank is better off because it has more control over the sale price, and it has a better idea of how long it will have to carry the property. The seller receives multiple benefits, including less stain on its credit (this varies with individual) and an easier sale. In many cases the buyer gets a cleaner title and does not have to go through the more intimidating foreclosure purchase.
There are also downsides to short sales; these are primarily the time it takes for bank approval and dealing with secondary liens. The lien issue is perhaps the most important in that a bank can only release its own liens, and cannot, in a short sale, remove a secondary lien as is automatically done in a foreclosure. Thus properties with large secondary liens – usually found as second mortgages or equity lines of credit – are not currently likely candidates for short sales.
The other impediment to short sales is the time it has been taking many banks to approve them, and to provide the documentation necessary for the process. There are currently some signs that banks are becoming more comfortable with the process; indeed, I suspect that short sales will become a larger and more accepted part of the residential market as more inventory floods many local markets. More on that below.
At this point it is useful to look at foreclosures and short sales in the context of a domestic relocation; there are several touch points between transferring employees, employers, and relocation management companies. The most interesting is on the departure side of a relocation, where an underwater employee would like to sell the house in a BVO (it could also be arranged in an AVO) program. Here the employee negotiates with their lender to lower the payoff of the note. There are companies that can perform this service, but in almost every state they need licenses (although real estate brokers are most often allowed to do so under state laws).
A significant amount of documentation – which varies from lender to lender—is required to convince the bank. The information usually includes current financials of the seller and a realistic valuation of the house. Traditionally, the borrower needed to provide a “hardship letter”, essentially a sob story detailing changed circumstances that make paying the existing mortgage difficult or impossible. Loss of a job, death in the family, or similar excuses are often the most successful. However, there are indications that banks are becoming much more willing to entertain short sale offers based primarily upon the underwater status of the house, and the borrower’s need or desire to move. In these cases the seller need not be in distress or even in arrears if the house is seriously underwater, though the combination gives even bigger incentive to the lender to agree to a short sale. If there are large secondary liens or large balance home equity credit lines on the property, these lien holders need to be involved, and the bank has to make its calculations knowing that they will also demand some portion of the sale proceeds. Interestingly, often one lender has provided both a purchase money mortgage as well as a second mortgage or home equity line of credit. One would think that the negotiations regarding a short sale in this situation would be easier because of this relationship; however, often this is not the case, as large banks tend to segment product lines into different administrative divisions. I predict that this will change as short sales become more mainstream.
The timing of the negotiations depends on the circumstances. Short sales are not approved until there is a contract of sale from the borrower to a buyer, but some lenders will begin the process at or before the time the house is listed, requiring appraisals or other evidence of value until a contract can be obtained.
Once the short sale documents are approved by the bank, it will issue a short sale letter which is in essence an agreement to forgive a portion of the principal of the loan. However, there will be other requirements, some of which make the sale ineligible for a relocation transaction. The most common of these requirements are the “claw back” provisions which are less commonly seen recently, but which are still a part of many agreements. Claw backs are a requirement that the bank can unwind the transaction in the event of misrepresentation or fraud; often the agreement limits the time period for the claw back to 60 or 90 days, but in any case, due to the two sale nature of the relocation sale, this makes such an agreement unacceptable. They are explained in detail here: http://www.worldwideerc.org/Resources/MOBILITYarticles/Pages/0810-Tax-Legal-Update.aspx
If the secondary lien holders agree, and if there is no claw back provision, the sale goes through as any other sale, the buyer receives clean title, and the seller is relieved of the mortgage.
However, the time required for banks to initiative and process the paperwork, especially where “hardship letters” were required has traditionally taken months, souring many deals. But I suggest that as short sales begin to take over an even larger portion of the market, banks will begin to devote more personnel to their processing, significantly shortening the processing time.
Current Short Sale Environment
As mentioned above, banks have been slow to warm up to short sales, even though they can be a money saving tool in the proper situations. But this will likely change as the need to get underwater assets off balance sheets continues. As an example, one recent statistic shows that in the San Francisco Bay market, 18.6 percent of all existing home sales were short sales in April, up from 17.6 percent a year earlier and 12.9 percent two years earlier.
One reason for banks’ reluctance is the threat of fraud; in fact, CoreLogic, a respected real estate research firm has just released its 2011 short sale report which both shows the three fold increase in short sales in the past two years, and also shows the potential for fraud in these sales. A summary can be found at http://www.corelogic.com/About-Us/News/CoreLogic-Releases-2011-Short-Sale-Research-Study.aspx
. Interestingly, this firm’s latest statistics also show that while first quarter real estate values fell over seven percent, year over year, the figure for non-distressed properties was less than one percent. Yet another reason for banks to consider short sales as an effective method of clearing shaky assets from their balance sheets.
Concerning the issue of fraud in the short sale process, several reported cases show a common thread: a real estate broker or investor approachs a homeowner and convinces the borrower to apply for a short sale, using fraudulently prepared appraisals or BPOs. Then, the property is sold to a straw purchaser and immediately resold to a buyer at a higher price. The current description of this process is “flopping”. The CoreLogic report estimates that banks stand to lose as much as $375 million in fraudulent flops, unless they take more risk management efforts to weed out fraud. This is not an uncommon recommendation regarding the disposition of any distressed property, but it is an indication that banks are becoming more involved in short sale processes as their numbers increase. This is good news to the extent that banks formalize the process, and likely portends faster approvals as staff is redirected to analyzing short sales.
Note that what makes a short sale illegal is the use of fraudulent valuations and a phony fist sale contract, and other failures to disclose to the bank. In essence, this is just a twist on the type of mortgage fraud that was rampant during the housing bubble. There are legitimate investors who approach banks to purchase houses on short sales, the difference is that there are no fraudulent appraisals, and the bank is aware that the investors will sell the house as soon as they can, for a profit. Not all banks will do these deals, but often it is cheaper than foreclosing.
Spurring banks to clear underperforming (or potentially underperforming) loans from their books was the recent announcement by the FDIC that banks may be required by regulation to maintain even larger capital cushions in the near future, as the agency has reservations about their ability to withstand a serious double dip recession.
If I am correct in assuming that banks will streamline the short sale process and will be more willing to extend them to more transactions, then it is also likely that more relocation transactions, both on the departure and destination side, will involve short sale paperwork. In my next blog, I will publish a short checklist for relocation transactions.