I rarely advocate That clients file Chapter 13’s because they take too long and keep them under the thumb of the bankruptcy court for (usually) five years.  So when does it make sense?

It makes sense when you want to keep your house but have junior unsecured liens stacked on top of the main mortgage.  In Chapter 7, if you want to keep your house, you have to keep the lenders current.  Not necessarily so in Chapter 13 when you have stacked loans secured by your home. Since 2006, the Heavy Question [see clever illustration below] has been:  Can you dump a mortgage loan in Chapter 13?  The short easy answer if you’ve ever read anything at all on my blog is that “it depends.”

First:  Is it “secured” solely by your primary residential real estate?  And by that I do not mean investment property or personal property.  (Pay attention here because the terms and definitions matter.)  That is, is the security agreement only applicable to your primary residence?  If so, you have passed the first test.

Second:  Is it WHOLLY unsecured?  By this is meant that there is no security for the loan at all after consideration of all senior debt.  Example:  House valued at $750,000 With a first deed of trust (“DOT”) for $690,000, a second DOT for $170,000, and  third DOT $75,000.  Now what?

Well, the first is wholly secured because the value exceeds the loan balance by $60,000 ($750,000 minus $690,000.)  Our hypothetical borrower can’t strip this lien because it is wholly secured.

The second is partially secured.  It is secured to the extent of the $60,00 left after accounting for the first DOT right?  $750,000 minus $690,00 leaves $60,000. Capiche?  So  because it is partially secured, you can’t strip it and the debtors will have to keep that lender current In order to keep the home.

But the third…Here’s where it gets interesting.  After accounting for the first and the second, there is no security value left for the third at all.  $690,000 plus $170,000 equals $860,000.  But the house is only worth $750,000.  Because the third is wholly unsecured, the borrower can “strip” this lien and shove the debt over to the unsecured column…Payable over the time of the Chapter 13 plan.

Why do we care? Because you can’t do this in Chapter 7.  It only works in Chapter 13.

This concept as described also only works in parts of the country, so don’t go charging into your bankruptcy lawyer’s office telling him or her all about how you read on the web that you can dump your HELOC. There’s a bit more to it than the above, but this sort of scenario and fact pattern is a good example of when a Chapter 13 might make sense.

 

On March 21, 2011, a Columbus, Georgia jury sent a very loud message to loan servicers in the form of a $21 million verdict and punitive damage award against PHH Mortgage, an affiliate of Coldwell Banker Mortgage.

David Brash, a sergeant in the United States Army, bought a home in 2007, and obtained a $161,000 mortgage loan from Coldwell Banker Mortgage.  The loan was serviced by PHH Mortgage.  Sergeant Brash had his monthly payments set on autopay out of his US Army paycheck.  (In fact, Sgt. Brash overpaid each month.) Things went along swimmingly for about a year and a half, until PHH began losing track of the payments, which then triggered the phone calls and letters telling him that he was delinquent.  A mortgage lender losing track of payments and blaming the consumer?  Say it ain’t so.  (The Complaint filed by Sgt. Brash’s lawyers in the case, David Brash v. PHH Mortgage (U.S.D.C., M.D. Georgia) case no. 4-09-CV-146 (CDL) is available for viewing here.)

Anyhow, that started a series of very patient efforts by Sgt. Brash to resolve the issue, all of which are thoroughly described in the Complaint. The servicer’s call center was outsourced to India. (No comment on that. I very seriously doubt that Sgt. Brash would have received better treatment from his fellow countrymen.)  But in an amusing instance of what’s-good-for-the-goose-is-good-for-the-gander, Sgt. Brash actually recorded the phone calls with the servicer (for quality assurance purposes right?), and the tapes of the phone calls were played to the jury. Transcripts of the calls were also admitted into evidence. I pulled the actual transcript of the phone calls from the Court’s docket, and you can review it for a good example of how to handle your own such calls. Very good evidentiary material that.

The upshot of the story? After multiple attempts to sort things out, PHH assured Sgt. Brash that things were resolved, and that the erroneously designated “late” payments had been properly credited. But then what did they do? You guessed it. They reported the false delinquencies to the Credit Cops, Equifax, TransUnion and Experian. This, in turn, caused Sgt. Brash to be denied credit. As stated in the Complaint, “Coldwell Banker Mortgage has refused to answer Plaintiff’s legitimate inquiries, and has refused to correct and straighten out Plaintiff’s account.”  (See Complaint, ¶48.)

If you’ve never seen what a $21 million judgment looks like, I’ve downloaded it from the Court’s docket, and have attached it here.  Also, check out the actual written jury verdict here.

Other than the obvious appeal of David taking on and beating up on Goliath–the sheer joy of seeing an abusive loan servicer get hit–the other appeal of this case is how meticulously Sgt. Brash documents his odyssey through this experience.  If you’re having trouble with your bank or loan servicer, read the Complaint that Charles Gower (Sgt. Brash’s lawyer) drafted, and review the list of trial exhibits. They are a roadmap for how to build and maintain a paper trail and document abusive loan servicer practices. This is the kind of evidence that wins lawsuits.

For lawyers who are keeping track, it appears that the gravamen of the legal theory was a violation of §2605 of RESPA.  (12 USC §2605.)

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.

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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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.

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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On August 28, 2009 the Kansas Supreme Court handed foreclosure advocates a major victory in the case Landmark National Bank v. Kesler.  The decision appears to be a fairly wonkish and dryly academic legal essay–and it is–but the implications could be monumental and could have some effect on more than 60 million mortgages in the United States.

Warning to the non-lawyer:  What follows is a somewhat technical discussion, and is probably more appropriate for lawyers or other mortgage industry professionals. The upshot of the Kansas decision is, well, it’s too soon to tell. It is clear that the MERS problem is growing, and will likely require some significant mortgage industry intervention to fix. Whether this decision offers any help to any particular person will depend on your situation. Obviously, a decision by the Kansas Supreme Court is binding only on Kansas courts, but this is a significant decision and may influence courts in other states. To my knowledge, no California court has yet dealt with the problem head on, though there have been some trial court decisions. (See, for example, Saxon Mortgage Services v. Ruthie B. Hillery, USDC, ND Cal. case no. C-08-4357 EMC. This decision is unpublished and not binding on any court, but it does suggest activity in the Northern District, and is probably just the beginning.)

So with that disclaimer out of the way…first some background.

MERS stands for Mortgage Electronic Registration System, and is a privately owned company that purports to acts as a “nominee” for millions of loans originated by lenders around the country.   (For the MERS home page, go here.  For a Wikipedia post on what MERS is, go here.)  I say “purports,” because that relationship is increasingly under attack in courtrooms great and small around the USA. Notably, the case referred to above, Landmark National Bank v. KeslerKansas Supreme Court, Case No. 98,489.

MERS was created in an attempt to simply the processes by which loans and mortgages are sold, securitized, assigned and enforced.  Basically the idea was to create a single “nominee” that would act in the place and stead of any one lender, so that when the need to enforce the loan terms or foreclose on the mortgage arose, the lenders wouldn’t have to chase around figuring out who owned what notes; they could just have MERS handle the entire transaction.

The Kansas Court, quoting a Nebraska court, described MERS as follows:

MERS is a private corporation that administers the MERS System, a national electronic registry that tracks the transfer of ownership interests and servicing rights in mortgage loans. Through the MERS System, MERS becomes the mortgagee of record for participating members through assignment of the members’ interests to MERS. MERS is listed as the grantee in the official records maintained at county register of deeds offices. The lenders retain the promissory notes, as well as the servicing rights to the mortgages. The lenders can then sell these interests to investors without having to record the transaction in the public record. MERS is compensated for its services through fees charged to participating MERS members.” Mortgage Elec. Reg. Sys., Inc. v. Nebraska Depart. of Banking, 270 Neb. 529, 530, 704 N.W.2d 784 (2005)

Good idea in principle. The problem that has come to the fore, however, is that MERS doesn’t actually own anything; it is just a named agent with a contractual power to enforce. And this is the problem that the Kansas Supreme Court  addressed…and which has more than a few mortgage-industry Chicken Little-sorts presaging that the sky will be falling soon.

The crux of the problem seems to be the pesky requirement that borrowers are entitled to know the identity of the person or lender to whom they owe money. That doesn’t seem unreasonable. If Larry lends money to Bob, and takes a promissory note, and Larry later sells that Note to Artie, Bob is entitled to know that, and only Artie can have the legal right to enforce the Note. If Bob has a problem with his loan, he needs to know the actual identity of the person with whom is in in a contractual relationship.

But the MERS system essentially does an end run around that requirement by saying that, “since we put MERS into the original note and deed of trust as a lender nominee, we don’t need to satisfy those notice and registration requirements. Courts around the country are increasingly saying “foul” top that arrangement.

Again, quoting from portions of the Landmark decision, in which that court quotes from other courts around the country…

The legal status of a nominee, then, depends on the context of the relationship of the nominee to its principal. Various courts have interpreted the relationship of MERS and the lender as an agency relationship. See In re Sheridan, ___ B.R. ___, 2009 WL 631355, at page 4 (Bankr. D. Idaho March 12, 2009) (MERS “acts not on its own account. Its capacity is representative.”); Mortgage Elec. Registration System, Inc. v. Southwest, ___ Ark. ___, ___, ___ S.W.3d ___, 2009 WL 723182 (March 19, 2009) (“MERS, by the terms of the deed of trust, and its own stated purposes, was the lender’s agent”); LaSalle Bank Nat. Ass’n v. Lamy, 2006 WL 2251721, at *2 (N.Y. Sup. 2006) (unpublished opinion) (“A nominee of the owner of a note and mortgage may not effectively assign the note and mortgage to another for want of an ownership interest in said note and mortgage by the nominee.”)

The relationship that MERS has to Sovereign is more akin to that of a straw man than to a party possessing all the rights given a buyer. A mortgagee and a lender have intertwined rights that defy a clear separation of interests, especially when such a purported separation relies on ambiguous contractual language. The law generally understands that a mortgagee is not distinct from a lender: a mortgagee is “[o]ne to whom property is mortgaged: the mortgage creditor, or lender.” Black’s Law Dictionary 1034 (8th ed. 2004). By statute, assignment of the mortgage carries with it the assignment of the debt. K.S.A. 58-2323. Although MERS asserts that, under some situations, the mortgage document purports to give it the same rights as the lender, the document consistently refers only to rights of the lender, including rights to receive notice of litigation, to collect payments, and to enforce the debt obligation. The document consistently limits MERS to acting “solely” as the nominee of the lender.

Indeed, in the event that a mortgage loan somehow separates interests of the note and the deed of trust, with the deed of trust lying with some independent entity, the mortgage may become unenforceable.

“The practical effect of splitting the deed of trust from the promissory note is to make it impossible for the holder of the note to foreclose, unless the holder of the deed of trust is the agent of the holder of the note. [Citation omitted.] Without the agency relationship, the person holding only the note lacks the power to foreclose in the event of default. The person holding only the deed of trust will never experience default because only the holder of the note is entitled to payment of the underlying obligation. [Citation omitted.] The mortgage loan becomes ineffectual when the note holder did not also hold the deed of trust.” Bellistri v. Ocwen Loan Servicing, LLC, 284 S.W.3d 619, 623 (Mo. App. 2009).

The Arkansas Supreme Court has noted:

“The only recorded document provides notice that [the original lender] is the lender and, therefore, MERS’s principal. MERS asserts [the original lender] is not its principal. Yet no other lender recorded its interest as an assignee of [the original lender]. Permitting an agent such as MERS purports to be to step in and act without a recorded lender directing its action would wreak havoc on notice in this state.” Southwest Homes, ___ Ark. at ___.

In any event, the legislature has established a registration requirement for parties that desire service of notice of litigation involving real property interests. It is not the duty of this court to criticize the legislature or to substitute its view on economic or social policy. Samsel v. Wheeler Transport Services, Inc., 246 Kan. 336, 348, 789 P.2d 541 (1990).

Essentially, the Court is saying that MERS has no rights to enforce. Of course, that could wind up being an overbroad interpretation, but the drums are beating nonetheless.  More will be revealed.