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.
In October, 2008 I wrote a blog post called “Are ‘Short Sales’ they worth the hassle?” My answer was a resounding and unequivocal “No!” (In fact my view was so lopsided that I think it could be said that it was really “Hell No!) Have things changed? Well, I have received some boots-on-the-ground intel that suggests that there may be some circumstances where the effort may pay off. I’m not ready to do a 180, but there may be circumstances where it’s worth a look. (The italics and bold of all those “mays” and “suggests” is intentional.)
First, let’s go back to the basis premise, which is that most people who bother with short sales do so out of a desire to “do the right thing.” An admirable motive in nearly any business endeavor. But it may not always be in one’s best interests. My objections to short sales is that they (1) Trigger too much effort and frustration, (2) Are prone to falling apart at the last minute, (3) Don’t do much to really salvage one’s credit rating and (4) Require the homeowner to do all the work for the bank. But the part that concerns me most is that in order to get a short sale approved, the homeowner has to open his financial books and records to the bank which may then turn around and use that very same information against the homeowner in a later lawsuit to recover a deficiency. Importantly, in California, a litigant cannot get financial information about the other party during the litigation. This protects litigants from allowing their financial condition to be the tail that wags the dog of the lawsuit: If someone can find out that the defendant is wealthy, they may press a frivolous lawsuit harder in the hopes that the wealthy target will cough up some money to make the problem go away. By giving a bank this information in the process of trying to get a short sales approved, you have now given them a possible road map to an easier recovery. For example, letting a property go in foreclosure forces the lender to consider a bankruptcy risk in their negotiating strategy; if you’ve told them that you have $100k in the bank or a stock portfolio, you have now minimized at least some part of that risk to the bank, and they’ll feel emboldened by knowing that you actually have something to lose. (For a related post on deficiencies after short sales, see my recent blog post about the new California statute CCP §580e which precludes a lender on a first deed of trust from pursuing a deficiency after approving and getting paid off in a short sale. This is a helpful development, but it doesn’t cover all situations.) Of course, the borrower’s ultimate financial exposure is never any greater than what the bank could get in a Chapter 7 or Chapter 13 payout, but making that determination is part of the analysis.
So what has changed? Well, I have been told that, anecdotally, letting a home go by short sale may enable a borrower to re-qualify to buy a new home sooner than would likely be the case in the event of a bankruptcy or foreclosure. In other words, a short seller takes a smaller hit on their credit profile than one who lets the property go by straight foreclosure. Again, this is only anecdotal and I have no proof or verification from any lenders or credit agency that this is true. But I have been told this by enough reputable real estate and loan brokers to believe that there might be something to it.
But don’t make this decision on your own: You need to know your risk of being sued before you make the decision. Get legal help. You should do a complete financial analysis so you know just how tempting a target you make to a bank. A $500 legal check-up may save you tens thousands of dollars–tens of thousands in some places–in later exposure.
Of course, you should never let a short sale go to close of escrow unless the bank gives you a complete waiver of a deficiency, but in the fog of war and after months of exhausting haggling with a bank, these things sometimes go unnoticed.
Call a lawyer before you close a short sale. Seriously. Do it.
Well, you know by now that the answer is: It depends.
If you file Chapter 7, and either are current or get current with your mortgage(s), then you can most likely keep your home. (Assuming you don’t have an equity interest that exceeds the homestead exemption. As to which, see this blog post: California Homestead Exemptions Increased as of January 1, 2010. Other California Bankruptcy Exemptions will increase on April 1, 2010.)
If however, you are in arrears, and are not able to bring the loan current, then–unless you can complete a mortgage modification that allows you to stay–you are likely lose the home.
On the other hand, if you file Chapter 13, and are able to successfully get a payment plan approved by the Court, then you may be able to stay. This is because in a Chapter 13, you can take the outstanding mortgage arrearages, and pay them back through the Chapter 13 plan over the 3 to 5 year commitment.
But don’t try to do this analysis yourself. Talk to a bankruptcy lawyer before you get too excited. There are lots of nit-picky little rules that can torpedo an otherwise possible successful Chapter 13. You need to do the analysis up front.
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.
I frequently hear from clients and prospective clients telling me that they have “rearranged” their financial affairs through the use of so-called “quitclaim deeds” or other contractual mechanisms by which title to property–and by extension–liability for a mortgage, is transferred. The most common appearance of this tends to be in the marital dissolution and property settlement context, where two divorcing spouses have divided the marital assets by “giving” property to each other, and one or the other has “assumed” liability for the mortgage. In concept this is a great idea. In reality, however, if there is a mortgage, it’s not all that useful. In fact, it is usually pointless.
This is simply because the lender’s rights are fixed as of the time of execution of the loan documentation, and the borrower can’t get out from under a repayment obligation simply by deeding the property to someone else. I won’t bore you with the legal language that is usually contained in the deed of trust, but suffice to say that, once on a loan, always on a loan until the loan is repaid or the lender specifically releases the borrower from the liability. Further, as a general legal principle, the loan obligation follows the property no matter who is on title.
An example might be in the case where the family owns two houses, a primary residence and a rental property, both of which are subject to mortgages, and both of which have both spouses’ names on title. When they divorce, the husband takes one and the wife takes the other as part of the marital property settlement. That’s great as long as the mortgages are being repaid. But if one of the parties gets into financial trouble, it will not be possible to inoculate the other from the consequences of a bankruptcy or default, because both parties are on the loans. Once on a loan, always on a loan until the loan is repaid or the lender specifically releases the borrower from the liability.
Of course this doesn’t mean that there aren’t solutions, but the quitclaim deed and assignment without the lenders’ consent are not real solutions.
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.
The attacks on the Mortgage Electronic Registration System (“MERS”) continues unabated at all levels. In the case MERS v. Johnston (Rutland County Superior Court case no. 420-6-09 Rdcv) another Court had held that MERS doesn’t have standing to complete a foreclosure of a mortgage which did not specifically name it as the mortgagee, or which secures a promissory note that didn’t specifically name MERS as payee. The opinion relied heavily on the Landmark National Bank v. Kesler decision from the Kansas Supreme Court that was issued in September of this year. The Kesler decision, in turn, relied heavily on the 2005 Nebraska Supreme Court decision Mortgage Elec. Reg. Systems v. Nebraska Dept. of Banking, 270 Neb. 529, 530, 704 N.W.2d 784 (2005).
It is still unclear just how much damage this line of cases will do to the infrastructure of the MERS nominee system. But at least one Federal Court has seemingly upheld the MERS system for at lease some purposes. On September 24, 2009, the US District Court for the District of Arizona handed down its trial court decision in Cervantes v. Countrywide (Case No. CV 09-517 PHX-JAT) in which the trial court determined that MERS is “not a sham,” as had apparently been alleged by the plaintiffs. This Arizona decision is only a trial court decision, however, and is not binding on any other court.
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.
NOTICE: This isn’t my post; It is a verbatim reproduction of the IRS’s FAQ on the Mortgage Forgiveness Debt Relief Act.
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.
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
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?
(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.
The Wall Street Journal recently ran an article about how, when small businesses are forced to file for bankruptcy protection, the inevitable result is that it usually takes the owners down with it. This is extremely common, and far more frequently the rule than the exception.
Why does this happen? Why, if the proprietor has gone through the expense and trouble to create a corporation or a limited liability company (“LLC”) do these things wind up being just so much superfluous window dressing right at the moment when you really need them to step up and do their job? (Their job being to protect your assets when things go sour.) Because the corporation or limited liability company formed for the needs of the of the small business owner usually doesn’t have adequate assets or resources to give any comfort to creditors–bank lenders most commonly–and so the lender wants as much security for the loans as possible. Enter the concept of the personal guaranty.
If ABC Corp. wants to borrow $1 million for an operating loan but only has assets of $50k of office furniture, computers, fixtures, etc., the bank is going to want some other security. And if ABC Corp’s sole shareholder has a few hundred thousand dollars in equity in his home, then the bank is going to want a security interest in that. Plus whatever else the owner may own. So the bank demands a personal guaranty from owner, which are usually so broad in what they cover that they renders the entire concept of the LLC or the corporation almost completely useless. And it happens with such efficient thoroughness and with such frequency, that it’s probably safe to say that if a personal guaranty is involved, then don’t even bother with the corporation or LLC. (Except maybe for tax or accounting purposes but we won’t go into that here.)
Another place where this pops up is in the single purpose LLC formed for the purpose of owning real property. I have taken quite a few people through Chapter 7s recently who had a bunch of LLC’s (or the increasingly popular Delaware “Series LLC”) that had been formed to own real estate. The problem is that banks won’t lend money for investment real estate to an LLC on the same terms that then will lend for owner-occupied residential property. They usually want 30% to 40% down depending on the asset. Why? Because the bank wants the owner to have “skin” in the game so that he won’t walk away.
So here’s what happens. (Or what was happening until things crashed in 2007.)
California resident finds great deal on 3br new construction home in Anytown, Utah (for example only). His real estate broker hooks him up with a loan broker to line up the financing. Owner has nothing to put down, and has read somewhere that investment real estate should be owned by an LLC to “protect his assets.” So Owner goes out and pays some lawyer $1,500 to form a fancy “Delaware Series LLC” for the purpose of owning the investment real estate in Utah. But here’s where the fancy plan derails: Bank won’t lend100% to an LLC, and the loan broker is usually too 1.) greedy 2.) stupid 3.) dishonest 4.) clueless to properly advise Owner. So Owner gets the stack of loan docs, all of which show that it is Owner as an individual, not Owner’s Delaware Series LLC that is the actual borrower on the loan. Deal closes and Owner gets his house. At this point Owner may transfer title to the LLC in the misguided belief that he is actually using this fancy legal device that he paid the lawyer $1,500 to create for him. After that Owner installs tenant, hires management service, and sits back to starts to collect the rent.
Things go great until 2007 or 2008 when the when the world comes crashing down. The house that Owner bought for $265,000 is now worth about $200,000 or less, the tenants have moved out, and because of the crash in housing prices, Owner can’t rent the property for enough to cash flow the loan, taxes and other expenses. Owner is now officially upside down (or under water) and is having to send checks form California every month just to meet the expenses. So Owner goes to a new lawyer. In many cases, this is me.