I have blogged several times in the past on the “the wisdom of short sales,” starting with complete opposition to the notion in “Are Short Sales Worth the Hassle”  and softening my position a bit in my post last December called “Rethinking Short Sales…”   Then effective in January of this year, the California State Legislature passed some new anti-deficiency legislation prohibiting first mortgage lenders who have approved a short sale from pursuing any deficiency on the balance.  I wasn’t impressed with that, as it didn’t seem do actually do much to help people in the final analysis.  Who cares about the first if you get sued on the second? Remind me what the point of that exercise was again?

For a variety of reasons, first mortgage lenders pursuing deficiencies is rare in California, but since I’ve already gone in exhaustive detail on how California anti-deficiency statutes work in these posts: “California anti-deficiency rules and statutes: When can a mortgage lender in California recover a deficiency after foreclosure?”;  “Second Mortgages in California: Deficiencies Not Usually an Issue” and “California Mortgage Deficiencies: What is a Purchase Money Security Interest?” I won’t reprise that here. But these posts remain the most visited pages on this website, so if you think you have a deficiency problem, these links may help you.

But I digress.

Earlier this year, the California legislature–one of the few that still seems consumer friendly–extended those short-sale anti-deficiency restrictions to all lienholders who approve short sales. What does this mean? It means any lender that approves a short sale is statutorily prohibited from coming after the borrower later for a deficiency.  Refis, seconds, thirds, HELOCs, so-called 80/20 seconds, home improvement loans, etc.  Bring ’em on.  If the lien-holder approves the short sale, no deficiency.  It’s the law!  It’s codified in CCP 580e.  But beware:  The lender must approve the short sale or the statute won’t apply.  (Of course, if you think about it, that’s sort a non-issue:  The essence of a short sale is such that it’s impossible if any lien holder withholds approval.)

Also, this only applies to California property. Lenders are still playing games in other states–here in the Western States–most notoriously Arizona.  I call this the game of “Bankers Keeping their Fingers Crossed Behind their Backs,” [see clever illustration above] as they give you an approval with one paragraph and stick it right back at you with the other. To put it nicely, it’s unscrupulous. Is it legal? Well, in places like Arizona it is. But not in California any more.

Read your short sale approval letter very carefully. What  you’re looking for is language that states either that the bank is “waiving” any deficiency, or that you are expressly “released” from further liability on the loan. If you think you might be seeing that language, but are not sure, call a lawyer for pete’s sake.  It’s worth a few hundred dollars to sleep peacefully at night.  (And don’t complain about your lawyer wanting to get paid for that opinion: She’s putting her reputation, personal fortune and insurance coverage on the line in giving you that comfort.)

I still don’t like short sales.  For a lot of reasons. But at least this eliminates one of the nastier and unexpected side-effects here in the Golden State.

 

The New York Times recently reported on a movement by the California State Legislature to amend California Code of Civil Procedure (“CCP”) §580b.  (See “Battles in California over Mortgages.”) For those of you who’ve been following along, CCP §580b is the California statute that prohibits a mortgage lender from obtaining a deficiency judgment on any loan that was used to purchase or construct a residence.   Such loans are referred to in the law as “purchase money loans.”  I have posted about this a couple of times (See posts:  California anti-deficiency rules and statutes: When can a mortgage lender in California recover a deficiency after foreclosure? and Second Mortgages in California: Deficiencies Not Usually an Issue), and it is a very important statute for California homeowners.

On June 3, 2010, the California Senate passed, by a convincing margin of 30 to 4, Senate Bill 1178 which extends the protections of CCP §580b to any loan taken out to refinance a purchase money loan, up to the amount of the original purchase money loan which is refi’d.  Here’s how that works:  I take out a loan for $500,000 which I use to buy my home.  A few years later, I refinance that loan with a new loan for $700,000, $500k of which goes to take out the original purchase money loan, and the other $200k of which I use for other purposes.  Under existing law, because the new loan is no longer a “purchase money loan,” but is a refi of a purchase money loan, I would not be protected against possible personal recourse by the lender if it foreclosed and did not recover enough on the sale of the residence to pay off the whole loan.  Under the new law–if it passes the California State Assembly–I would still be protected on the refinance loan up to the amount of the original purchase money loan that was refinanced, or in my hypothetical, $50ok.  That would leave me exposed on the balance in excess of that refinanced amount.  In my hypothetical, up to $200k.

Do we care?  Well, maybe some day someone will, but I doubt it.

As usual, the press gets it all muddled up, and everyone jumps on the band wagon to shout about “consumer protections.”  It’s actually somewhat comical.  If you Google “SB 1178 California” you get a whole raft of folks nattering about the great “consumer protections” it offers.  But if you know anything at all about how the economics and law of foreclosure in California actually work in day-to-day reality, a little reflection shows that it doesn’t do anything of the sort.

As a Bay Area real estate and bankruptcy lawyer who lives on the front lines–representing both lenders and borrowers–in these sorts of disputes every day, I’ll go way out on a limb here, and say with confidence, and in my most stentorian tone of voice, that this is a bunch of hogwash.  More political window dressing in the face of a crippling inability to do anything meaningful at all.  It’s not going to solve a single one of the problems facing California’s real estate industry today, and in practice, its benefits–if any–will be limited to an extremely small group of people who have more money than brains. The investor who made a wrong bet, but who can still afford to pay their debts.  (Which, ironically, is the precise subset that everyone who’s anyone in this debacle–from Hank Paulson to Bernard Bernanke to George Bush to the Barrack Obama–has steadfastly maintained they have no desire to help.  But I digress.)  Legally and economically, this is a red herring brought to you by a band of legislators who are largely powerless to do much more than wave their arms in sturm und drang trying to demonstrate to an increasing angry constituency that they are doing something.

Here’s why this thing is meaningless:

First, in order for this hypothetical to be a real problem, the lender would have to file an action for judicial foreclosure, because under the provisions of CCP §580d, no deficiency is available to a lender who forecloses by trustees sale.  If the foreclosing lender has availed itself of the “power of sale clause” in the deed of trust, then no deficiency is allowed. Period, done finished, end of story. That’s what CCP §580d is all about.  It doesn’t matter what the money was used for, how it was obtained, from whom, etc.  No lawsuit, no deficiency.  (A trustee’s sale is when they sell the property by auction on the Courthouse steps, and a judicial foreclosure is when they file a lawsuit in Superior Court seeking a judicial decree of foreclosure and money judgment.)

Second, the California real estate market continues to slog along the bottom of the river, which means that there are very few loans where the bank is going to be interested enough in the borrower to actually spend the time and money to chase a debtor on one of these.  The costs of foreclosure are already sky-high, (found by a Joint US Congressional Economic Committee to approach an average of $80,000 (!!!), see Joint Congressional Economic Committee Report on Foreclosure Costs), and the added costs and uncertainties of trying to pursue a deficiency on a mortgage balance in a court only adds more time, expense and uncertainty. Banks–and the regulators who regulate them–hate time, expense and uncertainty when it has to do with a non-performing loan.

The fact is that most lenders are not going to spend the money to launch a judicial foreclosure on a generic breach of contract claim. Which is what this foofaraw is all about.  When a borrower defaults on a promissory note by not paying it back it is just a simple, no-brainer breach of contract claim. Mortgage lenders in this sort of hypothetical don’t sue for that. Why?  Because it’s a colossal, herculean, humongous and uncertain waste of time and money.  And why is that?  Because the person they’re chasing either doesn’t have the money to pay them back–which is why they’re not paying in the first place–which means that if they actually get a judgment it will be an uncollectible judgment, i.e., a meaningless wallpaper, and…And here’s the big one, a generic breach of contract claim on a promissory note is completely dischargeable in bankruptcy. The lender can chase the borrower all the way to judgment and the borrower can still squirt out by filing a simple $299 Chapter 7 petition.

The person that they will sue, however, is the scam artist who got the loan by fraudulent means, and there is nothing at all in the revised CCP §580b that is going to protect that scam artist from the consequences of their fraud.

So who is this new and improved law going to help?  Here’s the profile: He/she is a borrower who doesn’t want to pay the loan back even though he/she has the money to do so. Further, they’re willing to spend this money that he doesn’t want to spend to avoid the foreclosure to finance litigation. Oh yeah, and one more data point.  The National Consumer Law Center recently published a report on average hourly rates for experienced consumer law attorneys, experienced being defined as those with 20 to 30 years experience.  Me and my colleagues in other words. (See NCLC United States Consumer Law Attorney Fee Survey)  The result? $460 to $475 per hour. So this hypothetical borrower doesn’t want to pay his loan, but he’s willing to pay me or my colleagues $475 an hour to litigate this issue.  Total likely fees? $50,000 to $100,000 at those rates. Where is this idiot?

So the new and improved CCP 580b is a pointless public relations stunt, and any blogger, journalist, banker, lawyer, real estate agent or politician who tells you otherwise is a well-intended liar or, more likely, just doesn’t know what they’re talking about. I suspect what they’ll say in response to me, however, is that removing this threat removes a negotiating plank–the threat of a lawsuit–from the lenders’ arsenal.

Last, the new law, if it passes, is likely only to apply to loans made after June 1, 2011.

Stay tuned.

In a couple of other places in this blog I have discussed various components of California’s mortgage anti-deficiency laws. (See California Mortgage Deficiencies: What is a Purchase Money Security Interest? and Second Mortgages in California: Deficiencies Not Usually an Issue.)  This post will put it all in one place. At least the five basic rules.

I can’t warn readers enough, however, that these are very, very complex issues. I have–quite intentionally–over simplified them here, and I have done this to provide a precis on the big picture.  The case law interpreting the applicable statutes occupies volumes in California lawyers’ offices, and there are still many legal issues and questions that are unsettled.  So please go easy if I don’t answer your specific question here.  There is no way I can address all of the issues in one post, so if you have a specific question, please, post it in the comment section so everyone can see it, and I’ll do my best to answer it. But if you think you have a deficiency problem, or a possible exposure to a deficiency judgment, you really owe it to yourself to see an attorney who understands these issues. Also, bear in mind that the rules vary from state to state, so if you are reading this post with a real estate problem in any place other than California, you can be sure that the rules applicable to your situation are not the same.

First, what is a deficiency? Simply stated, a deficiency is what is left owed to a lender after the lenders forecloses and takes the real estate back. Example: If I owe $200,000, and the property is only worth $150,000 there is a so-called “deficiency” of $50,000. When can the lender come after the borrower for that “deficiency?”  That is the subject of this post. And, of course, in the current economy, a lot of people are trying to figure this out.

In California, there are four primary rules that apply. I discuss them below in no particular order.

1.  The One Action Rule. CCP §726(a).

The One Form of Action Rule basically says that the lender is required to chase the collateral first, and the debtor second…if it still can. A long, long time ago, a foreclosing lender could choose whether to foreclose on the collateral or go after the borrower personally for a money judgment. The one action rule of CCP §726(a) says that the lender must go after the collateral first, and, if it is legally possible, go after the borrower personally for any deficiency after that. Whether that is possible will depend on how the other rules set forth below kick in and apply to protect the borrower. But if you get sued on a promissory note and the lender is not a “sold out junior” nor taken hasn’t taken steps to foreclosure on the collateral, this rule would apply.

(I use the term “sold out junior quite a bit in this post. A sold out junior lienholder is the holder of a deed of trust that is junior to the first lienholder, and who has been denied a recovery due either to the foreclosure by the first lienholder, or because there isn’t enpugh value in the property to satisfy the junior debt after satisfaction of the senior debt. It is common for people to refer to such debts as “HELOCS,” but this isn’t technically accurate. A HELOC is simple a “home equity line of credit” that is secured by the subject property. It may be the most senior debt on the property or it may be a second, third…or tenth lien in order of its seniority. “HELOC” is a banking term; “sold out junior lienholder” is a legal term of art.)

2.   The Purchase Money Prohibition:  CCP §580b.

This is the best known rule and the one that applies more often than the others. If the loan that is being foreclosed on is a loan that was obtained for the purpose of purchasing the property, then no deficiency is allowed. It doesn’t matter if it’s a first, second or third.  It doesn’t matter if it’s classified as a “HELOC,” a “seller carry back,” or, ultimately, a “sold out junior.” Purchase money is purchase money. Example: Homeowner buys a house for $300,000, with a first for $200, and a second for $60,000, both put on the property at the time of acquisition. If the first forecloses, both lenders are barred from getting a deficiency because both loans are classified as “purchase money.” However, where the borrower has refinanced the original purchase money loan, or got a later home equity loan, that later loan is not a purchase money loan and could form the basis for a deficiency if the other anti-deficiency rules don’t otherwise apply.

But there is an exception to the exception: If the later loan was used to finance improvements to the property, then it can be a purchase money loan, and thus be a bar to a deficiency.

3.  The Non-Judicial Foreclosure, or “Private Sale Bar”:  CCP §580d.

This is the next most frequent rule. If the foreclosing lender has availed itself of the “power of sale clause” in the deed of trust, then no deficiency is allowed. Period. If they take the property back by means of a non-judicial foreclosure or trustee’s sale, then no deficiency. But unless one lender holds both loans, that only applies to the loan actually foreclosed on. Using the above hypothetical figures, though in this case making the second a non-purchase money loan, when the first forecloses, the holder of the first foreclosing loan is barred from seeking a deficiency both (1) Because it is purchase money, and (2) Because it has foreclosed by trustee’s sale. But the second, not being purchase money, and not being the one who foreclosed by non-judicial sale but having been wiped out by the foreclosure of the first, is not barred from pursuing a deficiency. In fact, in California, they have up to four years from the date of the breach of the contract to file a lawsuit seeking that deficiency.

And of course, as noted, there is an exception to the exception: If the holder of the first and the holder of the second are the same lender, and that entity forecloses on the first, it is also barred from seeking a deficiency on the second. This is important in California where lenders sometimes “stack” loans in order to get to a loan amount high enough to cover the high property values. It is also important to think about when the loans may have been sold to different lenders.

(On a historical note, CCP §580d was passed in light of the foreclosures and abusive deficiency judgments obtained by lenders during the Great Depression.  What we’re going through now is similar in many respects, though the ability of lenders to take the property and then chase the borrower who is already out of their home is limited by the passage of that statute. Small solace, to be sure, but it at least is doing what it was intended to do.)

4.  The fair Value Limitation: CCP 580aCCP §726(b).

This rule limits the amount of any possible deficiency to the amount by which the total debt exceeds the total fair value of the collateral. It only applies to deficiency judgments in judicial foreclosures, and, most importantly, it does not apply at all to sold out junior lienholders. Example: First mortgage of $450,000, and a second for $150,000, for total liens of $600,000. If the holder of the first forecloses and, it can be shown first at the time the first forecloses it can be shown that the property is only worth $400,000, then the foreclosing lienholder–on return to court seeking a deficiency–is limited to $50,000, regardless of what they sold the property for.  So if they pay a commission of 6% ($24,000, and additional closing costs of $5,000, that $29,000 is generally barred.  As for the holder of the $150,000 second? They can still come after the borrower for full payment, assuming, of course, such an action isn’t barred by one or the other of the above rules.

5.  The 3 Month Rule: CCP §580a.

This rule applies only in the case of judicial foreclosures. What’s that? Literally, it is a lawsuit in which the lender obtains a “decree of foreclosure” from a court–by definition not using the trustee’s sale procedure–and is unable to be made whole from the sale of the property. Example: Loan balance of $500,000. Lender obtains a “decree of foreclosure” from a court, after which it then goes out and sells the property for $400,000. In order to get a recourse judgment against the borrower for the $100,000 shortfall, that creditor must bring an action within 3 months of the sale date or it is barred.  An important carve out on this rule is that the 3-month limit does not apply to a sold out junior lienholder, the holder of the second in the above scenarios.

It is highly doubtful that you will have to deal with this rule without being fully aware of the issue steaming down the tracks towards you, simply because it can only happen in a judicial foreclosure. A lawsuit. As to whether or not you’ve been sued, well, you should know it. But check out my prior post Second Mortgages in California: Deficiencies Not Usually an Issue I referred to in my first paragraph above if you’re not sure.

As David Letterman would say, “please don’t try this at home,” by which I mean simply that if you are concerned that you may have a deficiency exposure, call a lawyer. A real estate lawyer, not a family lawyer, a personal injury lawyer or your Grandma Tilly’s trust and estates lawyer. This can be complicated stuff.

And last, of course, if the debt is discharged in bankruptcy, there is no deficiency at all. But that’s another post altogether.

Okay, so misinformation and confusion about the tax implications of foreclosure arising from the cancellation of debt seems to be piling up.  In particular, folks seem most confused by the receipt of Form 1099-A from lenders who have taken property back in foreclosure.

First, remember the basic principle:  Cancellation of debt MAY result in taxable ordinary income. [Note added 3/31/11:  The link is to IRS Publication 4681. This is a 2008 version of this publication, and that as I write this addendum note in March 2011, the IRS has not updated the publication.]

Second, because a foreclosure is viewed as a “sale of property,” if you let real estate go in foreclosure and it results in a cancellation of debt, then that foreclosure may be a taxable event.

There are three exceptions:

1.   First, if the property lost in foreclosure is a principal residence–literally the home in which you live–then the cancellation of the debt (“COD”) generally won’t be taxable.  This is a result of the Mortgage Forgiveness Debt Relief Act of 2007.

2.  Second, if your are “insolvent” at the time that the debt is cancelled (not at the time of the foreclosure, but more on this below) then you will not be taxed. Insolvency is a simple balance sheet test: If your liabilities exceed your assets, you are insolvent. Don’t over think it. You will have to submit IRS Form 982 with the tax return in the applicable year in order to demonstrate that insolvency.

3.  Third, if the debt is cancelled as a result of a bankruptcy filing, then there is also no tax. (This is one of the reasons I call bankruptcy “the ultimate mortgage modification tool.”)

(Follow the “more” tag below for the rest of this article…The really good stuff.)

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Last year I posted on the subject of deficiency judgments in California. I’m not going to repost the same lengthy and technical post on the subject, but because I keep seeing this problem and questions about it all over the web, I thought I’d chime in one more time.

A deficiency is what is left on the debt after a lender forecloses.  Simple example: House worth $250k, debt of $450k, there’s going to be a deficiency of $200k.  It can be principal and interest on the specific loan that was actually foreclosed, or it can be a completely different loan, like a second or third deed of trust.  California is highly unusual and is very pro debtor in this regard.  More often then not, deficiencies are barred due to the generous anti-deficiency rules.

Here are those rules in a nutshell:

1.   There can be no deficiency on a purchase money loan. Ever. This means that if the loan was used to purchase the property, then no deficiency is possible. It doesn’t matter if the holder of the first, second or third forecloses. If the loan on which a lender is trying to get a deficiency is a purchase money loan, then no deficiency is possible. There are wrinkles in this: A HELOC can be purchase money. A loan taken out to refi a purchase money loan cannot.

2.   There can be no deficiency if the lender exercises its power of sale and conducts a non-judicial foreclosure by the mechanism of a trustee’s sale. In order to get a deficiency, the lender MUST file a judicial foreclosure action.  That means that they have to sue you in Superior Court. Some people seem confused about whether that piece of paper then got in the mail was a lawsuit or something else. It’s hard to miss: It’s a big 8.5″ x 11″ document called a “Summons,” and it says in unambiguous writing: “Notice to Defendant….You Are Being Sued By Plaintiff.”  See the blank one below.  I think you’ll agree that this is pretty clear.

3.   Most deficiency risk that remains after the weeding out of the two above rules can be discharged in bankruptcy.

Together, Rules one and two take care of about 80 percent of the deficiency concerns in California. These days, Rule 3 covers a large chunk of what’s left.

A question I am asked with increasing frequency is what happens to a mortgage modification negotiation when the borrower files bankruptcy.   Of course we all know by now that the answer is that “it depends.”

First, it helps to understand how most lenders staff these situations. There seems to be a common misconception that each loan and lender has a single, intelligent and rational professional banker assigned to it, who is charged with carefully weighing alternative courses of action, making intelligent decisions about each loan on an individual basis and maximizing the bank’s chances of earning the most return on its investment.  To that I say “fuggedaboutit.” Most lenders are in complete disarray and wouldn’t recognize a rational business decision on a loan-by-loan basis if it bit them on the nose. Remember, these are the same people that created this fiasco. It seems that the American banking industry has taken Will Rodgers seriously when he said, “If stupidity got us into this, why can’t it get us out of it.” I find it most useful to assume that there is no intelligent life on the other end of a telephone when I call a bank, an assumption which, while cynical, makes life easier by reducing my frustration when Forrest Gump answers.

The people tasked with analyzing and negotiating mortgage modifications are not the same people as those tasked with managing loans that fall into bankruptcy. So when you are negotiating for a possible loan mod and you file bankruptcy, in most cases the whole file gets transferred to someone else’s desk because the bank now has to take certain actions to protect itself that weren’t required pre-petition. They are going to shift into a different mode of “damage control.” That doesn’t mean that the loss mitigation folks can’t talk to you, but a bankruptcy filing is most definitely a game changer. (It is likely that, if you are able to actually negotiate a modification, court approval will be required, but that is a different subject and not within the scope of this post.)

Can you still negotiate a modification? Yes. There is no legal reason why a loan can’t be modified while the borrower is in bankruptcy. Will it happen? That depends on whether the bank keeps the loss mitigation representative involved in the game and talking to you (or your lawyer), and whether that person has a minimal level of motivation and intelligence, or whether they shut that process down.

In a situation I was recently involved in for a client, the lender had first denied the loan mod prepetition because the borrower’s income wasn’t high enough. When he resubmitted with different numbers, the loan mod was denied because he made too much.  After the bankruptcy petition was filed, and after the discharge was entered, the lender called me telling me that a loan mod had actually been approved. But when they sent me the documentation, all it was was a new, blank application intended to start the loan mod application process all over again.

Real chances of getting a loan mod are impacted by a lot of different factors, some logical and some which make no sense at all.  Bankruptcy may be a factor, but it doesn’t need to drive the end result.

After letting the world flounder for a year on what the Mortgage Forgiveness Debt Relief Act actually means, and how it intends to help taxpayers wade through the issues, the IRS has finally issued some insights.  I don’t believe this is the last word on this issue, and, for reasons I discuss elsewhere on this site, I suspect that this is just the start of many problems to come.  My crystal ball says that we won’t really understand the depth of this problem until 2013 or 2015 when the audits of taxpers from 2007 through 2010 start being conducted and wind through the courts.

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NOTICE:  This isn’t my post; It is a verbatim reproduction of the IRS’s FAQ on the Mortgage Forgiveness Debt Relief Act.

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If you owe a debt to someone else and they cancel or forgive that debt, the amount of the canceled debt may be taxable.

The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.

This provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion does not apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.

More information, including detailed examples can be found in Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments. Also see IRS news release IR-2008-17.

The following are the most commonly asked questions and answers about The Mortgage Forgiveness Debt Relief Act and debt cancellation:

What is Cancellation of Debt?

If you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes, depending on the circumstances. When you borrowed the money you were not required to include the loan proceeds in income because you had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount you received as loan proceeds is normally reportable as income because you no longer have an obligation to repay the lender. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.

Here’s a very simplified example. You borrow $10,000 and default on the loan after paying back $2,000. If the lender is unable to collect the remaining debt from you, there is a cancellation of debt of $8,000, which generally is taxable income to you.

Is Cancellation of Debt income always taxable?

Not always. There are some exceptions. The most common situations when cancellation of debt income is not taxable involve:

  • Qualified principal residence indebtedness: This is the exception created by the Mortgage Debt Relief Act of 2007 and applies to most homeowners.
  • Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
  • Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your total assets.
  • Certain farm debts: If you incurred the debt directly in operation of a farm, more than half your income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, your cancelled debt is generally not considered taxable income.
  • Non-recourse loans: A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income. However, it may result in other tax consequences.

These exceptions are discussed in detail in Publication 4681.

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 exclusion of income mean?

Normally, debt that is forgiven or cancelled by a lender must be included as income on your tax return and is taxable. But the Mortgage Forgiveness Debt Relief Act allows you to exclude certain cancelled debt on your principal residence from income. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.

Does the Mortgage Forgiveness Debt Relief Act 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. In addition, the debt must be secured by the home. This is known as qualified principal residence indebtedness. The maximum amount you can treat as qualified principal residence indebtedness is $2 million or $1 million if married filing
separately.

Does the Mortgage Forgiveness Debt Relief Act apply to debt incurred to refinance a home?

Debt used to refinance your home qualifies for this exclusion, but only to the extent that the principal balance of the old mortgage, immediately before the refinancing, would have qualified. For more information, including an example, see Publication 4681.

How long is the relief offered by the Mortgage Forgiveness Debt Relief Act in effect?

It applies to qualified principal residence indebtedness forgiven in calendar years 2007 through 2012.

Is there a limit on the amount of forgiven qualified principal residence indebtedness that can be excluded from income?

The maximum amount you can treat as qualified principal residence indebtedness is $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 and the detailed example in Publication 4681.

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 this form must be attached to your tax return.

Do I have to complete the entire Form 982?

No. 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 IRS Form 982?

If you use a computer to fill out your return, check your tax-preparation software. You can also 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 debt was forgiven?

Your lender should send a Form 1099-C, Cancellation of Debt, by February 2, 2009. 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. See Publication 4681 for further details.

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, you are not required to include forgiven debts in income to the extent that you are insolvent.  You are insolvent when your total liabilities exceed your 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. Publication 4681 discusses each of these exceptions and includes examples.

I lost money on the foreclosure of my home. Can I claim a loss on my tax return?

No.  Losses from the sale or foreclosure of personal property are not deductible.

If I sold my home at a loss and the remaining loan is forgiven, does this constitute a cancellation of debt?

Yes. To the extent that a loan from a lender is not fully satisfied and a lender cancels the unsatisfied debt, you have cancellation of indebtedness income. If the amount forgiven or canceled is $600 or more, the lender must generally issue Form 1099-C, Cancellation of Debt, showing the amount of debt canceled. However, you may be able to exclude part or all of this income if the debt was qualified principal residence indebtedness, you were insolvent immediately before the discharge, or if the debt was canceled in a title 11 bankruptcy case.  An exclusion is also available for the cancellation of certain nonbusiness debts of a qualified individual as a result of a disaster in a Midwestern disaster area.  See Form 982 for details.

 

If the remaining balance owed on my mortgage loan that I was personally liable for was canceled after my foreclosure, may I still exclude the canceled debt from income under the qualified principal residence exclusion, even though I no longer own my residence?

 

Yes, as long as the canceled debt was qualified principal residence indebtedness. See Example 2 on page 13 of Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments.

 

Will I receive notification of cancellation of debt from my lender?

 

Yes. Lenders are required to send Form 1099-C, Cancellation of Debt, when they cancel any debt of $600 or more. The amount cancelled will be in box 2 of the form.

What if I disagree with the amount in box 2 of IRS Form 982?

Contact your lender to work out any discrepancies and have the lender issue a corrected Form 1099-C.

How do I report the forgiveness of debt that is excluded from gross income?

(1) Check the appropriate box under line 1 on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment) to indicate the type of discharge of indebtedness and enter the amount of the discharged debt excluded from gross income on line 2.  Any remaining canceled debt must be included as income on your tax return.

(2) File Form 982 with your tax return.

My student loan was cancelled; will this result in taxable income?

In some cases, yes. Your student loan cancellation will not result in taxable income if you agreed to a loan provision requiring you to work in a certain profession for a specified period of time, and you fulfilled this obligation.

Are there other conditions I should know about to exclude the cancellation of student debt?


Yes, your student loan must have been made by:

(a) the federal government, or a state or local government or subdivision;

(b) a tax-exempt public benefit corporation which has control of a state, county or municipal hospital where the employees are considered public employees; or

(c) a school which has a program to encourage students to work in underserved occupations or areas, and has an agreement with one of the above to fund the program, under the direction of a governmental unit or a charitable or educational organization.

Can I exclude cancellation of credit card debt?

In some cases, yes. Nonbusiness credit card debt cancellation can be excluded from income if the cancellation occurred in a title 11 bankruptcy case, or to the extent you were insolvent just before the cancellation. See the examples in Publication 4681.

How do I know if I was insolvent?

You are insolvent when your total debts exceed the total fair market value of all of your assets.  Assets include everything you own, e.g., your car, house, condominium, furniture, life insurance policies, stocks, other investments, or your pension and other retirement accounts.

How should I report the information and items needed to prove insolvency?

Use Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment) to exclude canceled debt from income to the extent you were insolvent immediately before the cancellation.  You were insolvent to the extent that your liabilities exceeded the fair market value of your assets immediately before the cancellation.

To claim this exclusion, you must attach Form 982 to your federal income tax return.  Check box 1b on Form 982, and, on line 2, include the smaller of the amount of the debt canceled or the amount by which you were insolvent immediately prior to the cancellation.  You must also reduce your tax attributes in Part II of Form 982.

My car was repossessed and I received a 1099-C; can I exclude this amount on my tax return?

Only if the cancellation happened in a title 11 bankruptcy case, or to the extent you were insolvent just before the cancellation. See Publication 4681 for examples.

Are there any publications I can read for more information?

Yes.

(1) Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals) is new and addresses in a single document the tax consequences of cancellation of debt issues.

(2) See the IRS news release IR-2008-17 with additional questions and answers on IRS.gov.

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Now, I don’t mean to be overly flippant or anything, nor to be accused of promoting “irresponsible behavior” by advocating that people walk away from valid and legitimate debts, but I have to say that the single most effective “mortgage modification” tool for most borrowers these days is found the United States Bankruptcy Code.

So here–with a nod to Letterman for borrowed style points–counting backwards from 10 to 1, are the Top 10 Reasons why, more often than not, I advocate filing a bankruptcy petition instead of incurring the brain damage of trying to deal with banks.

(Lawyerly or, the obligatory “all things being equal” caveat:  This is true in many, but not all cases, and I’m assuming that the borrower has a fair and real choice between these two options.  Like with ANY legal remedy, it has to make sense for your particular circumstances, and, of course, the numbers have to crunch.   Bankruptcy is a technical and specialized area of law, so the decision should be made neither lightly, nor without expert guidance.  Things may also change over the coming months when–or more accurately, if–the lending industry gets its “mortgage modification” act together and actually raises their success ratio to something more respectable.  As it is now, in some areas, the default rate is as high (around 5%) as the “mortgage modification” success rate is low.  That’s a disgrace.

Anyhow, on with the Top 10 List.

10.    Bankruptcy doesn’t require you to bare your soul to some faceless, nameless banker only to have them tell you you’re not “qualified” for their mortgage modification program.  Of course, this is inane to start with:  If a borrower was “qualified” for the unaffordable, predatory loan that got them into the dilemma in the first place, how could they not be “qualified” for something more affordable now?   This is “bank logic” talking.  And it’s “bank logic” that caused this mess to begin with.  Arguing YOUR personal finance with a banker is like arguing about Halloween candy with an 8-year old. Generally, you can’t win this argument so why have it?  (For an absolutely classic example of this  absurd paradigm in action, check out this story on MSNBC.)

Recent reports suggest that only about 5% of attempted mortgage modifications are actually succeeding.  Success being defined as a negotiation that concludes with a new, supposedly more affordable mortgage. What about the other 95%?

First of all, the bank has probably squeezed another few months of interest payments out of the borrower as they strung them along leading you to believe that your “application” for a modification was being seriously considered.  And second, all the information you worked so hard to assemble for your banker will now to go into your “file,” to be used for who-knows-what-purpose.  Since I’m a lawyer, I’m paranoid by habit and profession.  I assume it goes into storage to be be puled out and used against you later when when the bank decides to sue you for a deficiency.

9. The lender doesn’t get a vote.  Generally, if you file a bankruptcy petition with a goal being to jettison a burdensome and onerous mortgage, barring something going seriously awry, you’re going to achieve that goal.  No matter what the bank has to say about it.  In the vast majority of cases, they don’t get to vote.

8. Bankruptcy is faster and will get you back on the road to financial recovery much faster than a bank sponsored “mortgage modification.”  Chapter 7 can be over and done with in as little as 3 to 4 months.  Chapter 13 can have you in an affordable payment plan even sooner.  In order to even qualify for a “mortgage modification” program right now, in most instances, you need to be at least 60 to 90 days delinquent before they’ll even talk to you.

Then, after you’ve prostrated yourself on the altar of some Loan Modification Committee of Third National Bank of Timbuktu trying to get a modification approved, or worse, had to deal with some newly minted “loss mitigation specialist,” you are likely to wait for another 3 to 6 months for any word.  Why?  Because they are up to their eyeballs in “loan modification requests” and they are noteager to make those painful modifications.  Banks are not modifying loans because they think it’s a good idea; they’re doing it because they have no choice.  But if they can suck a few more months of interest out of you then, in the bankers’ logic, they’re making lemonade out of lemons. It’s a get-what-we-can-while-we-can mentality.  If your financial statement leads them to believe that you’re a likely Chapter 7 candidate anyhow, it’s in their best interests to recover as much as they can before that happens.

7.     It’s (probably) cheaper.  This is a hard one to be sure of, but if you hire an attorney (or worse, one of these new “loan modification companies” that are popping up like weeds these days) to try to assist you with a mortgage modification application, and then pay him or her to run all that interference for you, your final bill is likely to be significant.  (And don’t shop for a mortgage banking/loan workout lawyer based on the low bidder.  You get what you pay for in the legal profession and there aren’t a whole lot of low cost lawyers who understand the law of mortgage and real estate finance.  (Mortgage, bankruptcy and insolvency law is not a first offense DUI or uncontested divorce where pretty much anyone with a bar card can get you through the process.  In banking law you get what you will get what pay for.)

In bankruptcy, most attorneys charge a fixed fee for taking the client all the way through the process, and those fees are subject to the approval (and possible adjustment) by the Bankruptcy Court.  Filing fees are relatively cheap, at present, $299 for a Chapter 7 and $234 for a Chapter 13.

Paying an attorney to try to get a home loan modification approved is tantamount to handing over a blank check.  As much as I love my profession and trust in the utmost integrity of my fellow members of the bar, only a fool gives a lawyer a blank check.

6. You don’t have to talk to any bankers.  Nothing personal to any of my banker readers (as if) but dealing with bankers is only slightly less painful and irritating than a root canal.  Contrary to what you may have heard, bankers don’t care about you.  Their job is to lend money and maximize their company’s return on investment, or, in this economy, minimize loss.  Converting an asset that is returning 8.5% interest into one that only returns 6.5% is going backwards.  Bankers created this mess.  I don’t believe it’s realistic to believe that they’re going to be the ones to fix it.

5. When bankruptcy is over, it’s over, and it feels very good.  Mortgage modifications are forever.  Or until you default again.

There is no doubt but that, in addition to the day they graduated from college, the day they were married, and the day their first child was born, other Red Letter Days in the lives of people who have endured financial stresses severe enough to make them consider bankruptcy, include the day they got their discharge and emerged from bankruptcy.  It’s like the relief one might expect to feel when you stop banging your head against a brick wall.  In my experience, I’ve never heard anyone who relieved themselves of mountains of unmanageable debt say they wish they hadn’t filed.  What I hear is that they wish they hadn’t waited so long.

4. You can’t get scammed by a bankruptcy court that’s giving you relief from the guy who scammed you in the first place.  LoanSafe.org is reporting that “loan modification scams” are one of the hottest new consumer ripoff industries.  I suppose they take a lot of different forms, but be careful.  At least lawyers have to be licensed, bankruptcy fees are subject to the supervision of the court, and loan modification scam artists generally don’t hang around in Federal court rooms wearing black robes.

3. The Bankruptcy discharge is forever.  More than half of mortgage modifications are headed for another default.  What do I mean by this? Well, first of all, a little background, and if you don’t want the background, skip the next paragraph and race to the “payoff.”

One of the Federal government’s official keeper of mortgage statistics is the Office of Thrift Supervision, known–as with any self-respecting government bureaucracy–by its acronym OTS. (OTS is a wholly owned subsidiary of the US Department of Treasury for those keeping track.)   Every quarter, OTS releases its “Mortgage Metrics” report, which is a 25 to 30 page impenetrable tome of economic gobbledy gook.  If you don’t believe me, here’s Q1 2008 and here’s Q2 2008.

Now the payoff:  The Mortgage Metrics Q3 2008 report will, when it is released, report that 53% of all mortgages that are modified wind up back in default.  This is what is being reported by sources that have seen it, or at least talked to people who have seen it.  My source?  MortgageDaily.com.

2. Bankruptcy is less stressful.  Financial fear and worry is one of the worst sources of stress that we can suffer from.  It’s only exacerbated when the cause of that stress is also the very roof over our heads.

1.     When it’s over, you get a REAL fresh start.  Bankruptcy is a financial reboot.  A whole new day.  Yes, if you are successful in completing a loan workout with your lender, there will be relief. Probably substantial relief.  But you also don’t get to start a rebuild, or get rid of other debts and liabilities that may threaten to drag you down again later.  If your oppressive mortgage is your only financial woe, then you may get some real relief from a mortgage modification attempt.  But those sorts of problems are not usually so isolated.

Again, I don’t mean to sound flip, nor to minimize the impact of having to file bankruptcy.  But if you are able to do so, and if your mortgage is only one part of a larger scheme of financial woes, what better way to “modify a mortgage” than to get rid of it?  Of course, this means that you will also lose the property, but in most of the cases that I’m reviewing these days, that isn’t a priority anymore. When the loan is $750,000 and the house is worth $600,000, what’s left to save?  (Those are Northern California numbers; your examples may vary if you live in other parts of the country.)

Upshot:  Know your options before you dive into a process that may not do as much for you as you hope it will.

Now, first off, I know that the title I’ve chosen for this post is about as unsexy and non-juicy as it can be.  That’s okay.  I can take it.  It’s boring.  I can hear marketing consultants hollering about how I need to make my title more grabby, sticky, etc.  Yawn. What can I say?  Trying to make this stuff fun and exciting is like trying to turn a root canal into a spectator sport.  And besides, if you’re reading this, you didn’t come here to be entertained.  Maybe someday I’ll change the title but for the moment it stays.

So, anyhow, on the subject of deficiencies…

Far and away the most common question I get asked by clients and potential clients is whether they will be liable for what’s called a “deficiency” after they let a property go in foreclosure.   Please note that the discussion below is limited to California law.  If your property is not in California–it doesn’t matter where you are; what matters is where the property is–then the discussion below will not apply to your situation because the laws in each state about foreclosures and deficiencies is unique to each state’s laws.

First, what is a deficiency anyhow?

A deficiency is, simply defined, the difference between what you owe on your loan(s) minus the value of the property at the time of the foreclosure.  Here’s an absurdly over-simplified example: You owe $250,000 on the loan.  At the time of the foreclosure, the property value is $200,000.  If the lender is entitled to a deficiency (and that’s a HUGE “if” in California) then it would be calculated at $50,000 ($250,000 – $200,000 = $50,000)

Lots of people right now are trying to weigh their options about whether they want to let a property go in foreclosure, file bankruptcy, do a “short sale,” try for one of those “deeds in lieu” or even try to work something out with the lender.  (Right!)  What I am seeing quite frequently is that decisions are being made based on completely wrong information about the extent to which they are at risk for

Next, how do you evaluate the risk of being chased for a deficiency by a lender after foreclosure?

Here are the rules in as simple a way as I can articulate them.  Remember:  THESE APPLY ONLY TO LOANS SECURED BY PROPERTY IN CALIFORNIA. If you don’t live in California, then these rules DO NOT apply to you.

1. There can be no deficiency on a purchase money loan. Ever. This means that if the loan was used to purchase the property, then no deficiency is possible. It doesn’t matter if the holder of the first, second or third forecloses. If the loan on which a lender is trying to get a deficiency is a purchase money loan, then no deficiency is possible. There are wrinkles in this: A HELOC can be purchase money. A loan taken out to refi a purchase money loan cannot. If you have multiple loans, then you have to think about the purpose of the loan.  Let’s say you have a purchase money first, and then you later took out a second. The second, because the loan proceeds weren’t used as “purchase money,” that lender is not barred from pursuing a deficiency in a lawsuit.

2. There can be no deficiency if the lender exercises its power of sale and conducts a non-judicial foreclosure by the mechanism of a trustee’s sale. In order to get a deficiency, the lender MUST file a judicial foreclosure action. That means that they have to sue you in Superior Court. Some people seem confused about whether that piece of paper then got in the mail was a lawsuit or something else. It’s hard to miss: It’s a big 8.5? x 11? document called a “Summons,” and it says in unambiguous writing: “Notice to Defendant….You Are Being Sued By Plaintiff.”  See a copy of one on my post “Second Mortgages in California: Deficiencies Not Usually an Issue.”