A consumer negotiating the terms of a mortgage with a lender or mortgage broker (henceforth “loan provider”) is in what economists term a “bilateral bargaining process.” Only two parties are involved, and the terms arrived at depend in part on their respective bargaining power.

Bargaining power is the power to influence the terms of the transaction by threatening not to do it. The bargaining power of borrowers is inseparable from the knowledge that they have it and their willingness to use it. Borrowers entering transactions with the mindset of petitioners seeking favors are not aware of having bargaining power, and as a result do not have any. They have potential bargaining power, which does them no good.

The potential bargaining power of borrowers is greatest on a refinance, because typically they have no time limit on when the money is needed. This usually means that they can break off negotiations with one loan provider and begin with another without being seriously inconvenienced.

In practice, many refinancing borrowers are solicited by loan providers and are unaware of their options. Abuses in connection with refinance solicitations were so common that Congress decided to protect refinancing borrowers by allowing them, within three days of closing, to rescind a deal with any lender other than the one holding their current mortgage. Borrowers who rescind have the right to recover all monies they have paid out in connection with the transactions.

The right of rescission is an extremely powerful tool that strengthens the potential bargaining power of refinancing borrowers. Unfortunately, most refinancing borrowers are not aware of what it does for them, and very few exercise it.

Home purchasers, at the early stages of loan shopping where they select their loan provider, have much the same bargaining power as those involved in a refinance. However, as the period to closing shortens, purchasers lose their bargaining power. They need the loan proceeds on a specific day — the day on which the contract of sale says the transaction will be consummated — and if there no longer is sufficient time to start the process again with a new loan provider, they are stuck.

Once past this point, the loan provider is in the driver’s seat. Both parties know that failure to close means loss of the house along with any deposit the purchaser has pledged. My file is stuffed with cases of home purchasers who had the mortgage terms changed on them when they were past the point of no return. Purchasers should finalize their negotiations, which means getting them down on paper, well before they reach this point.

What exactly should mortgage borrowers use their bargaining power to bargain for? In dealing with a lender, it can be anything the borrower is concerned with, but most borrowers would do well to focus on shutting down the two principal games that lenders play to improve their profit margins. One is to escalate their fixed-dollar fees, which existing rules allow them to do with impunity right up to closing. Borrowers can eliminate this game by requiring the lender to guarantee total fixed-dollar fees in writing. The total is all that matters — no fee-by-fee breakdown is necessary.

The second game is price lowballing, where lenders quote a rate and points below what they are prepared to deliver. (Points include all fees expressed as a percent of the loan amount). Because the market changes frequently, lenders cannot be held to a price until the borrower is ready to lock, which usually requires approval of the borrower’s application. When the time comes to lock, the lender raises the price to a more profitable level, explaining that that is the current market price.

To beat this game, the borrower needs to know exactly how his price will be set at the time it is locked. “We will price you at the market on that day” is a common — but not an adequate — answer because it doesn’t tell you anything you can check for yourself. “You can check the price we lock for you on our Web site” is a good answer, as they are not going to mess up their Web pricing program just to fool you.

The seven lenders I have certified as Upfront Mortgage Lenders can provide this answer, which is one of the reasons I certify them, but not many others can. If they shrug their shoulders and ask why you don’t trust them, it may be time to go to a mortgage broker.

In general, it is easier for borrowers to use their bargaining power to eliminate mortgage broker games than lender games. You need only to establish the broker’s total fee, including any fee paid to the broker by the lender, in writing. This protects the borrower against lowballing by broker or lender, and prevents fee escalation by the broker. The borrower should also require the broker to guarantee the lender fee as soon as the lender has been identified.

A court has considered whether borrowers owe taxes for the amount of debt discharged by a lender from a short sale of real estate.

George Stevens (“Taxpayer”) and his then-wife, Sharon Stevens (“Spouse”), purchased a residential property for investment purposes for $256,000. The property needed work, and so the plan was for the Stevens to put some money into the property and then either sell or rent it. The purchase was financed with a mortgage from Homecomings Financial (“Lender”).

Shortly after purchasing the property, the Stevens were unable to make a mortgage payment. In order to avoid foreclosure, the Stevens entered into a short sale agreement with a third party, with the approval of the Lender. A “short sale” occurs when the lender agrees to accept a sale price lower than the value of the loans secured by the property. The Lender imposed a number of conditions on the short sale, including limiting the amount of commissions and closing costs. The sale generated $181,461.31 in proceeds for the Lender.

Following the sale, the Lender sent the Taxpayer a Form 1099-C stating that it had canceled $74,494.96 in debt. A duplicate form was also sent to the Spouse (the couple had separated by this time). Neither the Spouse or the Taxpayer reported the discharged debt or property sale on their tax returns.

The Internal Revenue Service (“IRS”) found that the Taxpayer’s 2003 tax return had a deficiency of $21,323 and imposed penalties of $4,264 for the Taxpayer’s filing of an inaccurate return. The Taxpayer challenged this determination.

The United States Tax Court affirmed the IRS’s decision regarding the Taxpayer. In general, a taxpayer is required to include within his or her income all discharges from indebtedness. A sale of a property with a mortgage is generally treated as a sale upon which a gain or loss is realized. There are exceptions to this rule, such as when the sale resulting in the discharge of indebtedness is part of a bankruptcy case, or if the taxpayer is insolvent, or if the indebtedness is a qualified farm or business real estate debt.

While the Stevens claimed the property was for investment purposes, there was insufficient evidence for the court to evaluate whether the Taxpayer qualified for the business real estate exception. There also was insufficient evidence to determine whether the Lender intended to make a gift to the Taxpayer by forgiving the delinquency. Therefore, the court agreed that the difference between the short sale price and the loan amount, or $74,494.60, should be treated as ordinary income to both the Taxpayer and the Spouse as a discharge of indebtedness. Thus, the court upheld the IRS’s determination that the Taxpayer owed taxes on the discharge of indebtedness.

Next, the Taxpayer tried to argue that he did not owe a $4,264 penalty because he had a reasonable belief that the taxes were paid and acted in good faith, a defense a taxpayer can raise against the penalties. The Taxpayer argued that he assumed that the Spouse had paid the taxes for the discharge of indebtness because the tax bill had been mailed to her address. The court rejected this argument, as the Taxpayer acknowledged that he had also received the tax bill and there was no evidence that suggested the Spouse had paid the taxes. Therefore, the court affirmed the IRS’s imposition of a penalty.

In December 2007, President Bush signed into law the “Mortgage Forgiveness Debt Relief Act of 2007″. The new law applies to debt forgiven in 2007, 2008 or 2009. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, may qualify for this relief. In most cases, eligible homeowners only need to fill out a few lines on IRS Form 982.

What is the Mortgage Forgiveness Debt Relief Act of 2007?
The Mortgage Forgiveness Debt Relief Act of 2007 was enacted on December 20, 2007 (see News Release IR-2008-17). Generally, the Act allows exclusion of income realized as a result of modification of the terms of the mortgage, or foreclosure on your principal residence.

What does that mean?
Usually, debt that is forgiven or cancelled by a lender must be included as income on your tax return and is taxable. The Mortgage Forgiveness Debt Relief Act of 2007 allows you to exclude certain cancelled debt on your principal residence from income.

Does the Mortgage Forgiveness Debt Relief Act of 2007 apply to all forgiven or cancelled debts?
No, the Act applies only to forgiven or cancelled debt used to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes.

What about refinanced homes?
Debt used to refinance your home qualifies for this exclusion, but only up to the extent that the principal balance of the old mortgage, immediately before the refinancing, would have qualified.

Does this provision apply for the 2007 tax year only?
It applies to qualified debt forgiven in 2007, 2008 or 2009.  If the forgiven debt is  excluded from income, do I have to report it on my tax return? Yes. The amount of debt forgiven must be reported on Form 982 and the Form 982 must be attached to your tax return.

Do I have to complete the entire Form 982?
Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Adjustment), is used for other purposes in addition to reporting the exclusion of forgiveness of qualified principal residence indebtedness. If you are using the form only to report the exclusion of forgiveness of qualified principal residence indebtedness as the result of foreclosure on your principal residence, you only need to complete lines 1e and 2. If you kept ownership of your home and modification of the terms of your mortgage resulted in the forgiveness of qualified principal residence indebtedness, complete lines 1e, 2, and 10b.  Attach the Form 982 to your tax return.

Where can I get this form?
You can download the form at IRS.gov, or call 1-800-829-3676. If you call to order, please allow 7-10 days for delivery.

How do I know or find out how much was forgiven?
Your lender should send a Form 1099-C, Cancellation of Debt, by January 31, 2008. The amount of debt forgiven or cancelled will be shown in box 2. If this debt is all qualified principal residence indebtedness, the amount shown in box 2 will generally be the amount that you enter on lines 2 and 10b, if applicable, on Form 982.

Can I exclude debt forgiven on my second home, credit card or car loans?
Not under this provision. Only cancelled debt used to buy, build or improve your principal residence or refinance debt incurred for those purposes qualifies for this exclusion.

If part of the forgiven debt doesn’t qualify for exclusion from income under this provision, is it possible that it may qualify for exclusion under a different provision?
Yes. The forgiven debt may qualify under the “insolvency” exclusion. Normally, a taxpayer is not required to include forgiven debts in income to the extent that the taxpayer is insolvent.  A taxpayer is insolvent when his or her total liabilities exceed his or her total assets. The forgiven debt may also qualify for exclusion if the debt was discharged in a Title 11 bankruptcy proceeding or if the debt is qualified farm indebtedness or qualified real property business indebtedness. If you believe you qualify for any of these exceptions, see the instructions for Form 982.

Is there a limit on the amount of forgiven qualified principal residence indebtedness that can be excluded from income?
There is no dollar limit if the principal balance of the loan was less than $2 million ($1 million if married filing separately for the tax year) at the time the loan was forgiven. If the balance was greater, see the instructions to Form 982, page 4.

Is there anything else I need to know before filing?
Yes. Because the Mortgage Forgiveness Debt Relief Act of 2007 was passed so late in the year, the software systems used by tax preparers and at the Internal Revenue Service need to be updated to accept the revised Form 982. The IRS expects to be able to process the new Form 982 electronically on March 3, 2008.