(Updated February 2015)

A tax lien can be a major roadblock during a property sale or mortgage refinance. The IRS has initiated a program to ease this process, thus helping some homeowners save their homes or otherwise avert financial disaster.

The taxman, formerly the financial hit man of the federal government, is getting involved in measures to help the economy and housing market recover. A new IRS program establishes streamlined procedures for subordinating or discharging federal tax liens in order to enable certain homeowners to refinance their mortgage or sell their property.

New loan goes to front of line

The new program applies to homeowners who've temporarily fallen behind on their taxes as a result of the current economic downturn. Many beneficiaries will also be underwater on their mortgages as well; that is, owing more on the loan than the property is worth.

In most cases, a tax lien on a property makes it difficult to sell and virtually impossible to refinance the mortgage. That's because the lender issuing the new mortgage want to be sure that their loan is the primary lien on the property; that is, the obligation that gets paid first in the event of a default.

Tax liens, however, generally take first precedence in resolving any debt, so lenders avoid financing homes that carry such liens.

The new program will ease this burden by allowing certain tax liens to take a secondary position to mortgage-related liens, a process known as subordination. In other words, the tax lien is subordinated to the new mortgage, which becomes the primary lien on the property.

In some cases, the tax liens may even be discharged. That might involve refinancing the mortgage to obtain a lower mortgage rate or monthly payment, or doing a short sale on a home where the borrower is underwater on the mortgage in order to be free of the obligation.

It should be noted that discharge or subordination of a federal tax lien doesn't automatically eliminate the tax liability; that is a separate decision.

Helps both homeowners and the IRS

When announcing the program, IRS Commissioner Doug Shulman indicated that he didn't want his agency to inhibit distressed homeowners from taking steps to improve their finances.

Typically, when a homeowner owes past-due taxes, the IRS will file a Notice of Federal Tax Lien on his property, informing other creditors that the IRS has a legal claim. That claim then has to be repaid when the property is sold or refinanced - which can be problematic if the homeowner owes more in mortgage debt than the property is worth.

The IRS doesn't do this solely to provide relief to financially distressed homeowners, however. It has its own interests in mind as well. It may approve a subordination to ease the sale of a home so the tax lien can be paid off. Or it may approve a subordination on a cash-out refinance where the borrower will use to proceeds to pay off the lien. Or perhaps refinancing to a lower monthly payment will make it easier for the borrower to pay off the lien.

A key thing to remember: this program can only be used for federal tax liens; state and local liens for unpaid property taxes are not subject to the IRS policy.

Filing a formal request

Homeowners pursuing a mortgage refinance or loan modification should apply for a certificate of lien subordination. The application procedure is detailed in IRS Publication 784, How to Prepare an Application for a Certificate of Subordination of a Federal Tax Lien.

Homeowners who want to sell their properties may request a discharge of the tax lien. Usually, these requests are only approved when the homeowner is selling the property for less than what's owed on the associated mortgage debt.

Sometimes, the IRS will also discharge a tax lien if the homeowner has other assets that can be claimed. Instructions for this request are included in IRS Publication 783, Instructions on How to Apply for a Certificate of Discharge of Property from Federal Tax Lien.

Subordination and discharge requests are handled by the IRS' Collection Advisory Group. Homeowners are asked to contact their Collection Advisory Group as soon as the sale or mortgage refinance process begins.

Not doing so could delay the completion of the subordination or discharge, which would also hold up the closing of the property sale or refinance. Addresses and contact information for the Collection Advisory Group offices can be found in IRS Publication 4235.

Distressed homeowners who need to refinance or sell will certainly appreciate this new and softer side of the IRS.

Published on January 14, 2009