One of the sad truths of the Covid 19 pandemic is that while the housing market is hot, many people are in financial distress. Taxpayers with unpaid taxes receive scary letters that tell them the IRS intends to lien or levy their property. It’s important to understand the distinction between a tax lien and a levy. When the IRS levies your property, they take it. Except in the most dire of circumstances (called a “jeopardy levy”) the IRS will not levy a taxpayer’s principal residence. The IRS really doesn’t want to seize real estate because then they have to sell it to pay the taxes. It’s much easier for them when taxpayers pay their taxes in cash from the proceeds of a sale. But an IRS lien means that selling your property just got a lot harder.
While many people believe that they can’t sell their home if it has an IRS lien on it, it turns out that is a myth. E. Martin Davidoff, Partner in Charge of Prager Metis’ National Tax Controversy Practice, often helps individuals sell their homes and other property that are subject to an IRS lien. You can even sell if you are “upside down” in your mortgage (where the amount you owe is more than the home is worth). What you absolutely cannot do, however, is sell your home at a profit and expect to not have to pay your back taxes.
The most straightforward way to have an IRS lien removed from a property is to have it released. The IRS will release a lien when the taxpayer satisfies their outstanding tax debts. Of course, sometimes it is not possible to pay back taxes without first selling the property. Taxpayers mistakenly believe that because the IRS will get paid first in the event of a sale, that they cannot list and sell their property. That is not the case, but what is the case is that most mortgage lenders are reluctant to grant a mortgage to a potential buyer for a property that is subject to an IRS lien. When a taxpayer can sell their property at a gain and cover both the mortgage and pay the back taxes Davidoff recommends working with a tax controversy specialist to obtain a lien subordination. When an IRS lien is subordinated the bank is allowed to step in front of the IRS while the lien remains in place. That means the mortage gets paid first, but the IRS gets paid next. For highly appreciated properties and taxpayers who are highly motivated to settle their IRS debts, a lien subordination is a win-win. Taxpayers can apply for lien subordination using IRS Form 14134, Application for Subordination of Federal Tax Lien.
But what about when the property is “upside down?” If you owe more on your mortgage than what the home is worth, you might not be able to sell your property for a high enough figure to pay off both the remaining mortgage and your unpaid taxes. It is unlikely in this case that the IRS would allow a lien subordination. Nevertheless, Davidoff counsels that it is possible to request that the IRS discharge the lien. When the IRS discharges a lien, it does so only against a specific property. The IRS will still maintain liens against other property the taxpayer owns. A lien discharge is requested on IRS Form 14135, Application for Certificate of Discharge from Federal Tax Lien.
The major obstacle to obtaining a lien discharge on an upside down home is convincing the IRS that the sale price is the fair market value (FMV) of the property. In other words, don’t expect get a lien discharge for a discounted sale to a friend or family member. Expect to provide a qualified appraisal for an “arm’s length transaction” (i.e., a sale to a disinterested third party). The IRS may still discharge a lien for a non-arm’s length sale, but it may require two appraisals or one appraisal and a letter from a disinterested real estate agent willing to provide the expected amounts of a comparable sale in the area. Alternatively, the taxpayer can request the IRS consider an “equalization value.” Equalization is where property’s assessed value for property tax purposes is multiplied by an applicable factor to determine the property’s fair market value. For example, property is often valued at one-third of its fair market value for the purposes of assessing property taxes. Equalization would take the property tax value and multiply it by three to determine the property’s FMV for a sale. Taxpayers requesting lien discharge for sale to a related party should also be aware that the IRS uses third-party sites such as Zillow and Trulia to help establish FMV.
In all things taxes and real estate timing is key. Davidoff reminds taxpayers that the presence of an IRS lien makes it harder to close on the property, not harder to sell. Indeed it is possible for taxpayer to list and sell a property under an IRS lien but to be unable to close the transaction because of that lien. Even when everything goes right with respect to lien subordination or discharge, the process can take more than 30 days. In a hot real estate market the time it takes the IRS to process the paperwork may definitely exceed a buyer’s patience. Davidoff urges taxpayers to be prepared and to start the lien subordination or discharge process when they first decide that they want to sell the property.
Davidoff has the following tips to ensure a smooth closing process:
- Submit the application for subordination or discharge as soon as possible. It is not even necessary to wait for the appraisal. Note on the application that the appraisal has been scheduled and submit the application using the equalization amount calculated using county property tax records. The appraisal can follow.
- Allow up to 60 days for closing in any escrow paperwork. It is not necessary to disclose to a potential buyer that there is an existing lien on the property. Applying early and requesting a full 60 days for closing will typically ensure enough time for a smooth close.
- Get a payoff letter from the mortgage lender that spells out the exact payoff amount. That makes it easier for the IRS to do their job of evaluating the application. They know at the time of the application exactly how much the mortgage payoff will be and what (if anything) they can expect to realize by subordinating or discharging the lien.
- Hire a helper. The applications for lien subordination or discharge can get pretty technical and IRS processes and procedures can be difficult to navigate. When possible it is often beneficial to hire someone experienced with completing the forms and navigating the process. Sometimes these professionals will negotiate a discounted fee and/or can have their fees included as part of the sale closing costs.
Finally, as with most financial matters, it is important to not let the tax tail wag the situational dog. Sometimes the tax debt is close to the statute of limitations the IRS has for collecting it. It may be better to forego a bit of profit on a fast sale in a hot market to have a large amount of tax debt simply “fall off” the IRS books. Alternatively, filing bankruptcy may present a better option in a given situation than selling a property to pay a tax debt. Selling an upside down property could result in taxable cancellation of debt income from the mortgage lender, depending on the taxpayer’s circumstances prior to the sale. Taxpayers should completely evaluate the context surrounding their tax debt and their general financial situation before requesting lien subordination or discharge prior to a property sale. Davidoff reminds taxpayers that ensuring a thorough evaluation of all available options is one more reason to hire an experienced tax controversy professional to provide a complete plan of resolution for their tax (and other) debts. Using the proper option can sometimes even save the taxpayer enough money to cover the costs of hiring the professional.