How the IRS tax liability affects home buyers or refinancing

The Treasury Inspector General for Tax Administration reports that the tax gap, which is the amount of taxes owed versus what is paid, is approximately $441 billion. Many Americans owe back taxes, which can be a stressful experience. Additionally, IRS tax liability can affect home buyers or refinancing opportunities. If you owe tax liability and are considering purchasing a home or refinancing in the near future, consider contacting a knowledgeable tax lawyer with Damiens Law for advice and guidance. You can set up a confidential consultation by calling (601) 957-9672.

Credit risk

When a bank or other financial institution extends credit to a home buyer, they ultimately determine that the borrower is a worthy credit risk. Owing federal tax debt can decrease a borrower’s credit risk because the Internal Revenue Service (IRS) is a priority debt. Some lenders will refuse to consider a mortgage or refinancing application if a borrower owes money to the IRS.

IRS tax liability is different than other types of debts. A bank may not be as concerned about other types of liabilities because the bank will have priority over other creditors’ claims. However, if the IRS files a tax lien against a taxpayer, they can attach the home and take priority over the bank’s interest. This reduces the bank’s security that they will be repaid. Even if the IRS has not issued a tax lien, the bank still takes a risk by extending credit if a tax lien may be placed later.

Debt-to-income ratio

Another way that tax liability affects the ability of a person wanting to buy or refinance a home is that it impacts the borrower’s debt-to-income ratio. The debt-to-income ratio is a major component of mortgage and refinance applications. Lenders divide liability payments by gross monthly income. The lower the amount of liability you have, the better your ratio. The payments you make toward your tax liability are factored into your debt-to-income ratio.

Many lenders use a maximum debt-to-income ratio of 43 percent. They may reject borrowers who have a debt-to-income ratio that is greater than 43 percent. Owing the additional tax payment will potentially reduce the amount the buyer can borrow.

Effect on different types of loans

IRS tax liability affects home buyers or refinancing in different ways, depending on the type of loan.

FHA loan

According to the United States Department of Housing and Urban Development (HUD), you can still obtain an FHA loan. However, you may need to go through a manual underwriting process with HUD in which the lender establishes you have a valid agreement to repay the IRS and that you have made sufficient on-time payments.

To complete this process, the following steps are necessary:

• Set up a repayment plan with the IRS.
• Provide the repayment agreement to the lender.
• Make three consecutive on-time payments as required under the repayment plan
• Include the monthly payment amount in the liabilities section of the mortgage application.
• Obtain proof of the on-time payments.

Conventional loan

For conventional loans, the lender may include the monthly payment as part of the borrower’s monthly debt obligation instead of requiring payment and full as long as there is no indication that a Notice of Federal Tax Lien was filed against the borrower and the lender obtains an IRS installment agreement that sets out the terms of the agreement and that the borrower is current on the obligation. The borrower can assist with this process by requesting documentation of the agreement and proof of payment. They should supply this information to the lender as soon as possible to expedite the application process.

Tax liens

Tax liens can further complicate the matter. Tax liens indicate that the tax debt went unpaid for a substantial period that collection actions have been triggered. With a tax lien, the IRS can attach a lien on any property that could be liquidated to pay off the overdue taxes. The IRS’ security interest supersedes the lender’s security interest, which may make the lender hesitant to extend credit. Additionally, the lien applies to the time when the tax debt became owing, so it may predate the mortgage loan application.

Having a tax lien may cause the mortgage provider to be reluctant to extend credit or only to offer it a much higher interest rate. Individuals cannot apply for a Fannie Mae loan with an outstanding IRS tax lien.

Refinancing

A tax lien may make it impossible to refinance because this process creates a new debt obligation on the property. If a homeowner secured a mortgage before the IRS filed the tax lien, the mortgage provider would have the greater security interest. However, in the event of a refinance, the existing tax lien would have priority. Many lenders will not want to have their loan subordinate to another debt obligation.

Possible solutions to resolve tax liability

There may be various solutions to resolve tax liability in a way that does not jeopardize your ability to secure a home loan or refinance. Damiens Law can discuss if any of these options or alternatives can improve your situation:

Pay the tax debt in full

Rather than putting all of your savings toward a down payment, you may consider paying the tax debt in full. This will effectively lower your debt-to-income ratio if you already had a payment plan in place with the IRS. If you go with this option, you would need to have the debt paid in full before you close on the property. Speak to your lender beforehand about what type of proof it will require to show you paid off the debt and obtain it before closing.

Set up a payment plan

Many people simply do not have the money to pay off the entire debt. An option for them may be to set up an installment agreement with the IRS in which they agree to make a certain payment amount each month until the debt is paid off.

Borrowers will need to be strategic in how they set up their installment agreement. For example, some borrower might want to pay off the debt as quickly as possible and may opt for a higher monthly payment amount. If the debt is substantial, the borrower may wish to negotiate a lower monthly payment and longer repayment term. It will take some time to set up the installment agreement, so the borrower will want to factor this in when making plans. Additionally, this payment will affect the debt-to-income ratio, so the borrower may not be able to borrow as much as they originally planned.

It is important that the borrower make payments on time. Some loans will require showing a certain number of on-time payments to approve a mortgage or refinance application.

Make an offer in compromise

Another option to resolve tax debt is to make an offer in compromise to the IRS. This option allows a borrower to settle their tax debt for less than they owe the IRS. This may be an option for people who cannot afford to pay off the full debt or if paying it off would create a financial hardship for them.

Change priority of tax lien

Applicants can also request the IRS lower the priority of a tax lien in situations where the lien has already been issued. To do this, the applicant will need to get the IRS to accept a subordination agreement that states the tax lien will be secondary to the mortgage provider. Then, if the homeowner sells the house or the house is foreclosed on, the mortgage provider receives payment first before the IRS.

The IRS has the leeway to accept a subordination agreement when doing so would facilitate the receipt of tax payments. For example, the IRS is supposed to work with financially distressed taxpayers to avoid having a federal tax lien prohibit the refinance or sale of a property. If a borrower is refinancing the mortgage, they may agree to pay the difference between the old mortgage payment and the new mortgage payment to the IRS to pay off the tax debt. In this case, agreeing to a subordinate position to make a refinance possible might be in the IRS’ best interest.

Discharge the tax lien

Another potential option to resolve tax debt is to get the IRS to discharge the tax lien. This may be possible in certain situations, such as when the homeowner is:

• Selling the property
• Relinquishing ownership of the property
• Making a short sale on the property

The IRS may discharge the loan and provide certification of this if the borrower has sufficient equity in other assets.

Contact Damiens Law for targeted legal advice and guidance

While owing federal tax debt may not preclude your ability to buy a home or refinance your mortgage, it can complicate the situation. For a clear explanation on how IRS tax debt affect home buyers or refinancing, consider contacting a knowledgeable tax lawyer with Damiens Law by calling (601) 957-9672.