Generally, when a married couple divorces, they split assets between them according to the divorce agreement. When the family house is worth more than its purchase price — in what used to be the normal situation — any appreciation is included in the value of the home. The home is either sold and each spouse takes an equal share of the proceeds, or one spouse keeps the property with the positive equity counting toward his or her share of the property division.
In the case of an underwater mortgage, however, the home is worth less than the mortgage balance. This difference between a home’s original purchase price and its present value is negative equity, and it can be very problematic when it comes time to divvy assets.
One way for dealing with an underwater mortgage is to provide a “credit” to the spouse who keeps the home. In this, the couples compensate for the drop in value by providing that spouse a bigger share of another asset. For example, if a couple’s joint assets total $500,000, including a home worth $250,000, one spouse keeps the home while the other takes the remaining $250,000 as part of the divorce settlement — 50/50 split. However, if the couple’s home is underwater by $50,000 (the mortgage balance is $300,000), for example, the spouse who keeps the home is awarded an additional $50,000 to compensate for that negative equity, and the other spouse gets $200,000.
This routine does present the possibility for an uneven distribution of assets. Home values are depressed now, but are certain to improve later. If the home undergoes a short sale or foreclosure soon, it makes sense to provide the homeowner a credit for the negative equity because there will be no opportunity to recoup that loss. However, if the spouse plans to keep it long-term, it is very likely to regain some, if not all, of the value lost following the housing market crash. That means the homeowner doubles his or her money in receiving a credit while the home is underwater and then selling the property when values have recovered.
In some cases, rather than making up for the property debt by allocating a larger portion of another asset, the couple simply “zeros out” the debt. They do not consider the negative equity when assets are split, and the person with the home receives face value. If one spouse decides to keep the home as a long-term investment and anticipates a lift in value eventually, this is a better course.
Zeroing out the debt is not always a possibility, however, depending on the state of residence. Some states require that all assets and liabilities be divided in a divorce, including negative equity.
Selling the house at a loss is one of the less desirable options for dealing with an underwater mortgage. This is known as a short sale, and it is only possible if the homeowner is financially incapable of paying the mortgage payments and the lender approves it. A short sale, however, can prevent the lengthy headache of a foreclosure; however, it can still be detrimental to the personal finances of the spouses, who receive less for the house than what was originally paid. This may amount to which may amount to a loss of tens of thousands of dollars or more. A short sale also damages credit; it can make it difficult to acquire new loans and favorable interest rates in the future. Moreover, the lender may still hold the borrower responsible for loan balance.
A short sale requires that the parties are clear about the terms and condition of the arrangement, particularly that the negative equity does not become the responsibility of the spouses following the sale. Finally, a short sale may result in unexpected — and potentially significant — tax consequences.
The number of options available may be dependent on the state’s divorce laws. These options for can help determine the best course of action, but good legal and financial advice during the process is imperative.
A divorce is chaotic enough, but a house with an underwater mortgage makes a bad situation worse. Over 20 percent of homes are currently underwater, so it is a common problem.