One of the most common questions that we get surrounds how IRS tax debt impacts the decision to purchase a home. Home ownership is a goal for many individuals and families and owing money to the IRS can seem like an insurmountable obstacle. However, by no means does owing tax debt need to be a death sentence when it comes to the dream of owning a home.
Throughout the years we have helped several families manage their tax liabilities and achieve their goal of home ownership. With that said, taxpayers need to be realistic about the limitations of home ownership when you owe tax debt, both from the IRS and from your lender.
In this section, you will learn the truth about IRS tax debt and the consequences when it comes to buying or refinancing a home.
IRS Tax Debt and Buying a Home
First and foremost, let’s talk about what lenders are looking for when they loan people money for a mortgage. Lenders are ultimately looking for two things when analyzing a mortgage application: security and ability to service the debt.
IRS liability threatens both aspects for the lender. It is important that if you are planning on purchasing a house, that you shore up those two areas as soon as possible in order to make your dream purchase come true.
Security speaks to how comfortable the bank is about getting paid back based on the asset and its position in relation to other creditors. Typically, other creditors will not impact a mortgage decision when it comes to security because the bank will hold priority over the claims of those creditors. However, the IRS is a little different. When the IRS files a tax lien against a taxpayer that lien takes priority over the bank’s interest because the lien attaches to a taxpayer’s real and personal property as of the date that the tax debt was owed.
Even if the IRS has not filed a lien yet, having older tax liability still represents a risk to the bank because a lien could potentially impact the chain.of title. Furthermore, most lenders do not really understand the mechanics of an IRS lien, only that the lien represents a risk to the bank’s position as the lender. So, many of the larger and more conservative banks, will reject a mortgage application outright if the borrower has any existing tax liens.
Think of it this way: Tax liens grant the IRS a security interest in any property that you potentially acquire. Even if a lender is going to facilitate a mortgage, and even if that mortgage has a higher priority than the IRS lien, the IRS lien can still impede the lender's ability to collect equity from the property.
IRS liens can also have an impact on your credit score, which is an important factor for most lenders as well. Even if it does not lead to a flat-out denial, tax liens will usually have a negative impact on your score and, therefore, can raise your interest rates.
The other concern that tax debt speaks to for lenders is with the borrower’s ability to service the debt. First, most lenders will require that the borrower be in tax compliance before extending a mortgage loan. Even if a tax liability is small, not having an IRS installment agreement in place presents a risk to the lender because it raises the question of how you will pay the liability back. IRS liabilities that are unresolved means that you are not in compliance or do not have a payment plan, and will be looked on unfavorably by lenders. To the extent that you have a liability and that you are out of compliance, the lender may not grant you a loan until you get in compliance.
What if I own a home already? If I owe money to the IRS, are they going to take my house?
Let us start by saying that, yes, the IRS can take your house. If you are living in a house, and you own that house free and clear, and you owe money to the government, the IRS is either going to want you to borrow against that asset or they could potentially seize that asset.
That is a scary thought, but for example, if you are living in a multi-million dollar home and owe the government a million dollars, they are not going to want you to continue to live in your multi-million dollar home and owe the government a million dollars, so there is going to be a little bit of give and take there.
However, the good news from the perspective of most taxpayers is, number one, it is not very popular for the IRS to kick people out of their primary residences. Seizing primary residences and kicking people out of their homes does not play out very well in the media.
The IRS does not usually seize principal residences unless there are extreme or extenuating circumstances. Number two is, there is a lot of paperwork involved in seizing a house. The IRS agents have to fill out a whole bunch of forms. Those forms have to get multiple signatures on them.
They have to go through an attorney, and they have to go through a court process in order for the IRS to foreclose in your home. That is a lot of work. The IRS agents much prefer to go after low-hanging fruit. They go after cash assets. They go after bank accounts, they go after stock accounts, they go after wages, they go after things that they can very easily seize.
While they can take your house, that is not the first play in the IRS's playbook. Generally speaking, if you are proactive in resolving your tax liabilities, your house is generally safe.
The Effect that IRS Tax Debt has on Your Ability to Refinance
As we previously mentioned, IRS tax liens extend from the time period when the tax was due and owing. The problem with refinancing is that you are essentially re-doing a loan and creating a new debt obligation on a piece of property. So with your prior loan, if you had a mortgage before the IRS filed a tax lien, there’s no risk to the existing lender because their security interest was put into place before the IRS got involved.
However, the refinance of an existing obligation changes things quite a bit. With a refinance, the old loan obligation is cancelled and whomever owns the loan would be in a subordinate position to the IRS. The lender is not going to like having their loan subordinate to a tax obligation.
In these cases, you have a couple of options. The preferred option, at least to the lender, is for you to pull cash out of your home refinance and use it to satisfy the IRS and put the lender back into a first position. As a secondary option, the IRS may consider subordinating its interest to the lender in certain circumstances. Under the Internal Revenue Code, the IRS is able to accept a subordination when it would facilitate the payment of tax.
With a refinance, it is assumed that you are refinancing to receive a better interest rate and that, as a result of that lower rate, you are going to have to pay less to the lender every month. If you are willing to give the excess savings of the transaction to the IRS through an installment agreement, then they may approve the transaction. Keep in mind, however, if the plan is to pull cash out of the refinance and not give it to the IRS or to not otherwise confer some benefit to them, they have no incentive to agree to let you refinance your property. Ultimately, the IRS just wants to get paid.
As you can see, tax debt is not preferred when looking to purchase a home or refinance an existing mortgage and creates a secondary complication that you are going to have to deal with in order to complete your desired effect. This process can get complicated, especially because you are dealing with three parties with three competing priorities (you, the lender, and the IRS). However, if you have questions about this process, we encourage you to reach out to us and schedule a time to build a tax action plan. We think that you will find through the creation of your plan that this whole process is pretty manageable if you have a knowledgeable expert able to walk you through.