The income tax consequences of foreclosure and short sales have been the subject of much interest due to the mortgage crisis. This article will provide an overview of the major Federal income tax issues. However, it is not intended to provide advice on specific situations. Rather it will help real estate and mortgage advisors become more valuable assets to their clients by better understanding when to refer borrowers for professional assistance.
The income tax consequences of foreclosure and short sales have been the subject of much interest due to the mortgage crisis. This article will provide an overview of the major Federal income tax issues. However, it is not intended to provide advice on specific situations. Rather it will help real estate and mortgage advisors become more valuable assets to their clients by better understanding when to refer borrowers for professional assistance.
The fundamental concept is the Federal rule about Cancellation of Debt Income (CODI). Briefly, debt that is cancelled or forgiven generally results in ordinary income to the debtor, unless an exception, such as bankruptcy, insolvency, 2007 Relief Act, etc. applies. For unsecured debt the application of this rule is quite straightforward. If a man owes $25,000 on a credit card and settles with the issuer for $5,000, the man has $20,000 of CODI, which is ordinary income added to all his other income for the year.
However, for secured debts such as home loans, the application is much more complicated. For undisputed debts, CODI will only occur if fair market value is less than the loan balance and the debt is recourse (borrower personally liable).
The apparent simplicity of the determining fair market value is deceptive. The unanswered questions are who determines value, and what the standard is. [Section 580a of California’s Code of Civil Procedure (CCP) provides for a hearing to determine fair market value. But that hearing is normally only used in the rare cases of judicial foreclosures seeking deficiency judgments; this at least suggests that non-judicial foreclosures can never have deficiencies, as there is no 580a hearing.] Lender Form 1099 show values that suggest little concern with accuracy, e.g., a recent 1099 showing a value of $777,777.77.
The more complex legal question is whether the loan is recourse or non-recourse. Loans can be recourse (or not) by contract or by operation of law. Essentially all home loans are recourse by their terms. So to become non-recourse, it must be by operation of law (or by agreement). Here, it is important to note that the I.R.S. allows recourse to change to non-recourse without being a taxable event, and the character at the time of the debt cancellation that controls. Recourse status must be determined under state law, so there can be different results (and tax consequences) for different states. In California two sections of law interact to determine a lender’s ability to pursue the home borrower personally. CCP 726, the Security First rule, requires the lender to foreclose before it can proceed against a borrower personally. Lenders violating this law can lose both the security and the loan.
The other laws affecting recourse are the anti-deficiency laws. These prevent the lender from pursuing the borrower personally after the triggering event. Nearly half the states have anti-deficiency laws. California’s include CCP 580b (any purchase money primary residence loan foreclosure), CCP 580d (non-judicial foreclosure of real estate secured loans), and CCP 580e (residential short sales). [Note: as of June 2011, CCP 580e applies to 1-4 unit residential firsts and seconds in short sales.]
The combined effect of these two sections of law in California (and states with comparable laws) is to prevent residential lenders from ever acquiring the right to proceed against the borrower personally. CCP 726 requires the lenders to proceed against the property before the borrower. After foreclosure CCP 580d bars any personal action against the borrower. So at no time can residential lenders proceed personally against the borrower. [In the virtually unheard-of event that a lender tries a judicial foreclosure, the lender still does not acquire the right to pursue the borrower personally until after foreclosure and a CCP 580a hearing to determine fair market value and whether any deficiency exists.] Caution: different analysis will apply in the case of a “sold-out junior”; where the first has foreclosed, the second deed of trust then becomes “legally worthless” and not subject to the Security First rule. Purchase loans for primary residences (including seconds) are protected by 580b even in judicial foreclosures.
The foregoing determinations can have a critical effect on the borrower’s tax liability (or lack). If the loan is non-recourse at the time of the cancellation of the mortgage debt, the U.S. Supreme Court ruled in Tufts v. Commissioner (1983) that the disposition is treated as a sale for the outstanding balance of the mortgage. However, this rule only applies where there is a disposition of the home (e.g., foreclosure or short sale); a loan modification or settlement, in which the borrower retains the property, can result in CODI if one of the exceptions does not apply.
This analysis has been limited to California law. Other states may have comparable provisions. Borrowers should seek an attorney’s opinion for the result in those states, as state law may determine whether a loan is non-recourse. This article does not address the consequences of other alternatives, such as deeds in lieu.
By becoming familiar with the rules for their states, brokers and other advisors are in a position to refer borrowers for professional assistance and recognize improper reporting by lenders after foreclosures or short sales. If a borrower receives a Form 1099 from the lender showing erroneous recourse status or fair market value, the first step is to write the lender requesting a correction. If the lender refuses or fails to respond, the borrower’s tax preparer should report the disposition correctly and attach an explanation of why the lender 1099 is incorrect. While brokers and others in the real estate field should not offer firm conclusions on these tax issues, a basic knowledge of this area will make them a valuable resource to refer clients to qualified tax advisors familiar with the state’s laws.
By William P. Matz, B.S., J.D., LL.M. Attorney/broker William P. Matz focuses his law practice on real estate, finance, and tax. Having also run an active mortgage business since 1992, he has a unique perspective on the mortgage crisis. He practices in Windsor, CA 95492, (707) 837-2161 ext. 121.
