Question: I am applying for a new home loan. I purchased a condo in 2006 and I had 2 mortgage loans. The first loan was foreclosed in 2009, but the 2nd loan still had a balance of $59,000. I claimed insolvency on my 2009 tax return and was advised to not pay or negotiate with the collection agency that bought the 2nd loan.
I thought by claiming insolvency, the 2nd mortgage would be considered a charge-off. I am surprised to see that my credit still shows an open, unpaid balance. How do I fix this so I can purchase a new home?
Answer:I am not an attorney and strongly suggest you seek competent legal advice; however, I believe claiming insolvency is solely an IRS remedy, not a personal credit solution.
It is an established principle of taxation that a discharge of debt results in a gain to the debtor. Since the 2nd mortgage was purchased by a collection agency, the original creditor charged-off your debt. As odd as it sounds, the bank’s loss is viewed by the IRS as a gain to the debtor.
The reasoning is that when the loan originated, you didn't recognize income because you were obligated to repay it. If repayment did not occur, you somehow experienced a gain. While foreclosure is never really a gain, you are still accountable for the bank’s loss; unless you can prove insolvency.
In your situation you were able to claim insolvency with the IRS but that has nothing to do with the unpaid 2nd mortgage now held by the collection agency. As long as debt is unpaid, you can be pursued by a collection agency. But, the debt can only remain on your credit reports for 7 years from the date it was charged off by the original creditor.
Even though insolvency means your assets total is worth less than your debts which is the same as having a negative net worth, it has no affect on your credit reports and nothing to do with the collection agency which purchased your debt.
The only way your credit report would be changed is if you entered into an agreement with the collection agency to repay the 2nd mortgage. If that were the case you could have negotiated a pay for deletion or simply a “settled” notation on your credit reports. As long as the debt remains unpaid, it can appear on your credit reports until it reaches the 7 year mark from the date it was charged-off by the original creditor.
Disputing the listing is one option; but, if you are successful in the dispute process, there is always a chance the listing will re-appear on your credit reports or another collection agency will purchase the debt and come after you. But keep in mind, even if another collection agency purchases the debt, the date on which the debt is due to drop off your credit reports does not change. It can only remain, by law, for 7 years as dictated by the Fair Credit Reporting Act.
Since you are interested in purchasing a new home, a mortgage company or bank may require the 2nd mortgage be settled. The good news is that if you settle, there is a possibility to negotiate a settlement for pennies on the dollar.
But if you go with FHA, the standards are less strict. And, if your credit report is otherwise good, you may have an excellent chance to get a new mortgage. When I say good I mean low balances on your credit cards and no late payments on your current obligations.
FHA may not require you to resolve the 2nd mortgage however you are likely to have your application referred for manual underwriting. Manual underwriting means a loan officer will take a hard look at the facts and circumstances of your collection or disputed accounts. But again, your chances are good with FHA because they do not hold collection accounts that are 24 months or older against you. The best of luck to you.
