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.

On May 9, 2010, the CBS news magazine show 60 Minutes did a segment on strategic defaults. Nothing new here, but when 60 Minutes gets its hands on something you never know where it’s going to go.

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.

The California Homestead exemption (found in CCP §704.730 for those keeping track) was increased as of January 1, 2010.

The Homestead Exemption is the amount of equity in excess of existing liens that the homeowner can protect from levy by creditors.  So if your home has a value of $500,000, your existing mortgage balance is $400,000 and you fall into the $75,000 homestead category, then $75,000 of the $100,000 equity cushion in your home is protected from creditors.  This works in bankruptcy and out.

Here are the new limits:

  • $75,000:  Basic homestead for single person
  • $100,000:  Head of household
  • $175,000:  Over 65 or physically disabled or under 55 with less than $15,000 in annual income ($20,000 if married).

The full text of the statute appears below.

The exact numbers of the California Bankruptcy Exemptions will be released by the Judicial Council on or about April 1, 2010, and published by the Administrative office of the Courts.  The actual published limits are harder than hens’ teeth to find on line, even if you know what you’re looking for.  But here is the current published list of  California “Current Dollar Amounts of Exemptions from the Enforcement of Judgments.”  You can check back here on my site for an update when they release the new numbers on April 1, 2010.

California Code of Civil Procedure ("CCP") §704.730

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.

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.

May 11, 2010 UPDATE since original post:   60 Minutes with Morley Safer did a piece on Strategic Defaults on May 9, 2010 that you may want to check out.

Following on the heels of my post the other day on the Option ARM perfect storm that’s brewing in the San Francisco Bay Area, the LA Times recently ran a piece on the growing phenomenon of“strategic defaults”, by which is meant the intentional defaulting on a mortgage loan by a borrower despite an ability and the wherewithal to make the payments. In other words, just walking away.

Why would someone do this? Simple: The debt far exceeds the value of the collateral by such a margin that continuing to make the payments can no longer be justified by sound economics or abstract moralizing, guilt, sense of duty or any other non-economic reasoning. In other words, the numbers just don’t crunch any more.

The Wall Street Journal Economic Insight Blog also recently ran a piece on the subject in June, called “When is it cheaper to walk away?” The answer, according to the writers of that piece is 10%. When the balance of the loan is more than 10 greater than the value of the property, economically, it makes more sense to just walk away rather than keep making the payments.

The WSJ articles was, in turn, based on a very thorough paper prepared jointly by the University of Chicago School of Business and Northwestern’s Kellogg School (under the auspices of the Financial Trust Index). The paper, called WHEN HOMEOWNERS WALK AWAY: NEW RESEARCH REVEALS MORE THAN 25 PERCENT OF MORTGAGE LOAN DEFAULTS ARE STRATEGIC” concludes about 25 percent of foreclosures are “strategic,” meaning intentional and driven by larger economic considerations than merely the borrowers’ ability to make the payments, and that…

Homeowners start to default at an increasing pace, and walk away massively after decreases of 15 percent and more. In fact, 17 percent of households would default, even if they can afford to pay their mortgage, when the equity shortfall reaches 50 percent of the value of the house.

As for “strategic bankruptcy,” this is just the next step after the “strategic default.” (I wrote about this last year in an only-partially tongue-in-cheek “Top 10″ list for why bankruptcy is the “ultimate mortgage modification tool.” I won’t repeat myself here.)

What does all this mean? Well, for one thing, it means that what we’ve known all along is now starting to attract the attention of economists and journalists.

As for what it might mean for an individual or family? Probably not much frankly. It seems to be giving an academic gloss to what people tend to know at a gut level anyhow: That we’re not out of the woods yet, there are lots more foreclosures and bankruptcies to come, and the housing market probably has a few more bumps in the road awaiting it before things smooth out.

As to whether this data or these reports can help you or anyone you know as you wrestle with difficult decisions: whether to default, whether to file bankruptcy, what other options you have, it probably can’t. Everyone’s situation is unique. Just like everyone else’s as the old saying goes. But before you decide that you’re going to “strategically default,” or file a “strategic bankruptcy,” you should consult bankruptcy counsel. There are lots of moving parts, and the amount of your home loan and the value of your house are just two pieces or a much larger puzzle.