As readers of my Blog know, there has been very, very little help provided by any government programs that theoretically are to help troubled homeowners keep their homes.  Even less help has been provided by the lenders.  The original Hope For Homeowners program failed to get lender cooperation. This was followed last year with the Home Affordable Mortgage Program (”HAMP”) which also has failed to deliver any substantial help to upside down borrowers.  And now, effective April 5th, the government will open their newest program, the Home Affordable Foreclosure Alternatives Program (”HAFA”).  Significantly, this Program is being introduced as a part of the HAMP program but it has nothing to do with helping people keep their homes. Rather, it is designed to assist lenders in getting the existing owners out through a short sale or deed in lieu of foreclosure. 

The sad reality of HAFA is that it effectively gives the lenders what they wanted… a politically correct reason to deny modifications (which they don’t want to do) and a faster way of getting the existing owners out (which they do want to do). So, for upside-down owners, there’s no help in HAFA.  But for our economy, the results may be even worse.

Today’s real estate market, especially in California, is operating on an artificial economy.  The lenders are holding back putting all of their foreclosed properties on the market. This keeps the supply down and keeps prices up.  The lenders could put more properties on the market but that increase in supply would cause prices to fall since demand by buyers is not growing. The result of this is that the lenders have been slowing down the foreclosure process so they don’t get more properties that they’ll just hold back.  But since all of these must eventually get sold, this means that it will be many years before our real estate economy is not driven by the lender’s inventory of foreclosed homes. And, thanks to HAFA, it may now get much worse.

Under the rules of HAFA, all lenders that participate in the HAMP program must participate in HAFA. This means that if a lender denies a homeowner a modification under HAMP or the modification fails or is not accepted, the lender must offer the homeowner a short sale or a deed in lieu of foreclosure and our government (we the taxpayers) will pay the lenders and borrowers to participate.  This will speed up the change of ownership.  But what will be the effect on the already over-supplied real estate economy?

According to the lending industry information service, Mortgage News Daily, as of the end of 2009, only 4.3% of all HAMP modifications resulted in permanent loan modifications. Over a million trial modifications are in process. Unless the permanent modification numbers increase dramatically, we could be facing an additional 950,000 short sales and foreclosures coming on the market.  This would be a disaster as these get added to the already over-supply driving down the values of property. Existing buyers, investors, and lenders would be scared away from an unstable market and the problems in the economy would become even worse.

Is there any solution?  Well if the objective is to help people keep their homes through loan modification, then there needs to be a way to compel lenders to reduce principal amounts owed. If lenders continue to refuse, then Congress should pass the Chapter 13 Bankruptcy Reform which the Senate shut down last year. Alternatively, compel lenders (particularly BofA) to waive deficiency recourse so that everyone can move on.

Sadly, there remained no Hope for Homeowners in that program and Making Home Affordable has not made homes more affordable. HAFA gives up on the hope of helping owners stay and instead will only help owners go. Unfortunately, this may hurt us all.

If you have any questions concerning your rights and obligations concerning real property, foreclosure, or any related issues, please feel free to contact me at stevebeede@bpelaw.com or contact my office at 916 966-2260 for a confidential appointment by phone or in person.

Short Sales are a difficult process at best and they are made worse by numerous uncertainties, most particularly in the case of lenders demanding further payment from the Sellers. Faced with such demands, some sellers may find it is more financially prudent to simply walk-away and let the property go to foreclosure.  However, such action may expose a seller to damage claims from the Buyer or agents.

A short sale involves four separate contractual agreements:

1.   THE LOAN(s) - A loan is a contract between the borrower and the lender made up of a promissory note (the promises to pay the loan back) and a security agreement (pledging the property as security for repayment). Depending upon the laws of the particular state, the lender may be able to get a money judgment against the borrower if the loan does not get paid in full. A short sale arises when the Seller owes more on the loan than the selling price of the property. Generally, the seller/borrower is seeking to get the lender to release any liability claims on the shortage.

2.  THE LISTING AGREEMENT - this is a contract between the seller and a real estate broker. The seller hires the broker to locate a buyer and sell the property. If successful, the seller pays a commission to the broker. In a short sale, success is also contingent upon the lender agreeing to the short sale but the conditions of that consent are often not spelled out.

3. PURCHASE AND SALE AGREEMENT - this is a contract between the seller and a buyer setting forth all of the obligations of both parties. A short-sale form of this contract adds a contingency for the lender to consent to the sale. Again, typically the terms of that consent are not spelled out.

4. CONSENT AGREEMENT - this is a contract between the seller and the lender stating the conditions under which the lender will agree to the short sale. Since the short sale changes the obligations under the loans, consent by the lender and seller to these changes is necesary for the short sale to close. The most important issue for both seller and lender is whether the lender will have recourse against the seller for any loan amount not paid in the short sale. This contract is where this issue is decided.

 Every contract comes with what is called an “implied promise” that all parties to the contract will act in “good faith” and with “fair dealing” in carrying out their obligations. Thus, at a basic level, the borrower must pay the loan; the broker must find the buyer; the buyer must be ready to buy; and the seller must be ready to sell.  What happens however if the lender demands recourse or more payment against the seller?  Can the buyer force the seller to sell?  Alternatively, can the buyer and agents collect money damages and commissions from the seller if the seller refuses to sell?  The best answer is…look to the contracts.  Does the seller have any good faith basis upon which to refuse to sell if the lender demands recourse?

As readers of my Blogs know from prior articles, the right of a lender to get recourse against a borrower if they’re not paid in full depends upon the language of the loan documents, how and when the loan was made, and the application of real estate law in the State. Rarely does a loan document ever expressly state that it is “non-recourse”. Instead, nearly all loans are written as being “recourse” even though the lender’s actual rights to recourse will be governed by the above factors. This is where the conflict with short sales arises. A lender has no obligation to take a penny less than they are owed in order to enable a seller to sell their property yet that is what the seller typically wants. This conflict is resolved - or not - in the Consent Agreement. If resolved, the sale goes through. If not, the sale dies and the property likely goes to foreclosure. So the key question, is when must the seller consent or, alternatively, when can the seller walk-away from the short sale without liability?  The legal answer should be found in determining if the seller acted with “good faith and fair dealing”.

For example, in California if a borrower gets a loan to purchase a 1 to 4 unit property that they live in, this is called a “purchase money loan” and the lender has no recourse against the borrower if the loan is not paid in full, regardless of what the loan documents may say.  In contrast, if that same borrower later refinances the property, the new loans are not purchase money and therefore the lender would generally have recourse.  Unfortunately in most short sales, this distinction is not considered in drafting the Listing Agreement or Purchase and Sale Agreement. And so, the parties are blindly proceeding expecting the lender to give up recourse and only then considering the impact if the lender refuses.  This could make the seller and possibly the seller’s broker liable for damages if the seller refuses to accept a short sale with recourse.

Since the seller/borrower should know up front when the lender has recourse rights in their loan, the seller really does not have a right to be surprised by a recourse demand in the short sale agreement. Therefore, ”good faith and fair dealing” reasonably would require them to complete the short sale with recourse (if it couldn’t be negotiated down).  Refusing to do so could make them liable for financial damages to the buyer and the buyer maybe even be able to force the sale.  In such situations, it is reasonable that the seller’s broker and agents could similarly be liable for the buyer’s damages (and the commission of the buyer’s broker) for putting the property on the market with the implied representation that if the lender accepts the short sale buyer, the seller will close the sale.

In contrast, where there is no recourse in the loan (such as in the purchase money loan referenced above), the seller could reasonably claim that they were acting in good faith and fair dealing in rejecting a short sale consent agreement that gives the lender more recourse in the short sale than they would have in foreclosure. Is the seller right in this claim?  Well, on the one hand, it was not unreasonable for the seller to expect that the lender would not increase the seller’s liability merely because it is a short sale. On the other hand, in a voluntary transaction such as a short sale, the lender is not bound by what it could do if it foreclosed.

So, my conclusion is: “Yes”, the Seller can be liable to the Buyer in walking away from a short sale.  More importantly, since the seller’s broker is providing the Listing Agreement and advising the seller on the contents of the Purchase and Sale Agreement, the brokers - both seller’s and buyer’s - owe a fiduciary duty to their clients to provide for this type of contingency.  At the simplest level, the Listing Agreement and Purchase and Sale Agreement should reference the conditions under which the seller will be bound to accept the lender’s Consent Agreement.  If the Seller is to be able to walk away if the lender demands recourse, the Seller’s broker should make sure that that contingency exists in the Purchase and Sale Agreement.  Similarly, the buyer’s broker should make an early evaluation of the recourse on the seller’s loans and so advise the buyer of the walk-away risks before the buyer invests a lot of time and money.

Short sales are hard enough for everyone and are stressed with the uncertainty of the lender’s response to the seller’s short sale request.  It is within the diligence ability of all of the parties to have a better understanding of how the seller will likely respond if the lender demands recourse before the Purchase and Sale Agreement is made.  If the parties took this step, a lot of anguish, frustration, and legal liability could reasonably be avoided.

If you have specific questions about your liability, short sales, foreclosure, or any legal issue, feel free to contact me at sjbeede@bpelaw.com or call us at (916) 966-2260. Need help Coping with an Upside Down Loan? Checkout Steve’s audio-seminar and e-book at: http://www.stevebeede.com/copingwithanupsidedownmortgage/.

The content of this Article is for general information purposes only and is not to be relied upon as legal advice. Be sure to consult a knowledgeable real estate attorney in your State for advice on your particular situation.

As borrowers continue to grapple with upside-down loans and short sales and foreclosures continue to climb, the risk of debt forgiveness tax becomes more important, especially for investors who do not have the personal residence exclusion from Federal taxes on forgiven debt.  “Debt Forgiveness” occurs when the lender doesn’t get paid all that they are owed and they are not going to pursue you for any unpaid balance.  Although the risk of a judgment on the unpaid balance goes away, you can be taxed on the amount of forgiven debt as if it were income you had earned,. This is often called “Phantom Income” because you never really saw it but you are still affected by it.  As I discussed in prior Blogs, the Federal government has relief from this tax on personal residences through 2012. California has no relief.  Luckily, both have an “insolvency Exclusion” that may apply and which can enable a debtor to otherwise avoid being driven into Bankruptcy. Since Bankruptcy has far greater potential negative consequences than a short sale or even a foreclosure, the possibility of avoiding these taxes without filing Bankruptcy is important. Here’s how the Insolvency exclusion works.

As set forth in full on IRS Publication 4681 “Cancelled Debts, Foreclosures, Repossessions, and Abandonments” http://www.irs.gov/pub/irs-pdf/p4681.pdf, Insolvency is determined by first listing the fair market value of all of your liabilities immediately before the debt forgiveness event (short sale or foreclosure). Next you list the fair market value of all of your assets at the same point in time.  Next, you subtract your assets from your liabilities. If the result is zero or less, ie: your liabilities exceed your assets, then you are insolvent.  Page 6 of Publication 4681 has the actual worksheet you can use to make this calculation.  Once the insolvency is determined, you report this on your tax return through the use of IRS Form 982 http://www.irs.gov/pub/irs-pdf/f982.pdf. 

California appears to draw it’s insolvency determination from the IRS Form 982. California’s taxing agency is the Franchise Tax Board (”FTB”). As stated in the FTB Tax News dated February, 2010 http://www.ftb.ca.gov/professionals/taxnews/2010/February/Article_8.shtml “if the loan is recourse indebtedness and the debtor incurs cancellation of indebtedness income (CODI), IRC Section 108 provides certain exceptions in recognition of that income. One of the exceptions applies where the taxpayer was insolvent (total liabilities exceed total assets) when the CODI was realized. The exclusion only applies up to the amount of insolvency, i.e., to the extent the liabilities exceed the FMV of the assets”. However, California law does not conform to all of the provisions currently available in IRC Section 108.

The key is this:  If you are an upside-down borrower facing a debt forgiveness tax as a result of a short sale or foreclosure, you may be liable for debt forgiveness tax and may queslify for the insolvency exclusion. Be certain to get tax advice from a qualified professional who can look at your specific situation and advise you on how these rules apply to you.  This Article is solely intended to give you an introduction to what might be available for you but you should not rely on it to apply to your financial circumstances.

If you have specific questions about your liability, foreclosure, or any legal issue, feel free to contact me at sjbeede@bpelaw.com.  Need help Coping with an Upside Down Loan? Checkout Steve’s audio-seminar and e-book at: http://www.stevebeede.com/copingwithanupsidedownmortgage/.

Every upside-down property owner is aware of the risk of a lender seeking a deficiency judgment for any amount of the loan that remains unpaid after short sale or foreclosure. Depending upon the laws of the state where the property is located, they may or may have any such right.  This issue of “recourse” is the first thing that I, as a real estate attorney, look at when advising borrowers and is the #1 reason that short sales fail (learn more in previous blogs).  But lately the question has been arising about whether a Mortgage Insurance Company has recourse if they pay-off a deficiency.

Private Mortgage Insurance (generally called PMI) is typically required by a lender anytime you borrow more than 80% of the purchase value of the property being acquired. In essence, you buy an insurance policy to protect the lender from the increased risk of loss with a higher loan-to-value ratio.  So you pay and the lender is the beneficiary. Here’s where it gets tricky.  An insurance policy is a contract between you and the insurance company for the benefit of a beneficiary. Like any agreement, the rights of the parties are governed by the terms of the contract and the laws of the State.  You pay for the policy in order to get the benefit of the lender giving you the loan… not for the benefit of avoiding a deficiency if there is a default (although this may be a reasonable belief if it is even considered at the time of the loan).  Thus, the policy may protect the lender from a deficiency and protect you from the lender’s claims but the policy may also provide that you must reimburse the insurer for any such payouts.  This is similar to your auto insurance which may pay a damaged third party for injuries suffered in an accident which you caused. The policy pays the injured party and you may have to reimburse the insurer for all or a part of what they pay out.  Again, the language of the insurance contract governs the rights of the parties.

But in the upside-down homeowner situation there are additional confusing issues. First, there must be an actual deficiency between the amount owed and the amount the lender receives.  If the lender has no recourse, they’ll generally give you a 1099 from which you may be liable for debt forgiveness tax.  But, if the debt has been forgiven, how can the PMI insurer claim recourse?  Second, since the insurer is communicating with the lender and not you, how can they hold you liable for a claim of which you had no knowledge and no input?  Third, since the only real purpose of the PMI is to insure injury resulting from a default by the borrower, then - unlike the auto accident - it is the default that is being insured, not obtaining the loan and therefore there should not be any recourse right for the insurer.

As of this point is time, we are not aware of any cases in which insurance companies have actually filed lawsuits against borrowers seeking PMI recourse. Such cases may be going on at the local Court level and have not reached the visibility (and legal authority) that only arises from an appeal after a Judgment to a Court of Appeals.  Given that a breach of contract claim such as failing to reimburse an insurer must be brought within a certain period of time after the breach occurs (such as 4 years in California), we may wait a long time before there is any certainty how Courts will treat such claims.  Further, if and when those cases are brought, there may be a great difference in rulings by different courts. It is the appeals process that starts to bring uniformity to decisions.

So the short answer to whether a Mortgage Insurer can get a Deficiency Judgment is “maybe”.  However, as set forth above, if any such suits are brought there many defenses that borrowers can argue to protect themselves. Even more effective may be the reluctance of judges and juries to further punish upside-down borrowers especially when the lenders (that arguably created this problem) get made whole.

If you have specific questions about your loans, liability, foreclosure, or any legal issue, feel free to contact me at sjbeede@bpelaw.com or call us at (916) 966-2260 for a phone or personal appointment.  We offer a $200 flat fee attorney consultation to enable you to evaluate your judgment and tax risks and to plan a strategy to minimize or even avoid them.  Need help Coping with an Upside Down Loan? Checkout Steve’s audio-seminar and e-book at: http://www.stevebeede.com/copingwithanupsidedownmortgage/.  

As readers of this Blog are aware government efforts to help upside down homeowners keep their homes have been a failure.  First, lenders are not willing to make the principal cuts needed to bring loan balances to an affordable level; and second, government lacks the political will to force the issue.  But this does not stop them posturing.  Last year it was “Hope For Homeowners” and this year it is the “Home Affordable Modification Program”. Both promised loan balance and payment reductions. Both have been a failure since Congress has been unwilling to force the issue by passing Bankruptcy cram-down authority.  HAMP has been especially frustrating because lenders have been offering “trial modifications” with reduced payments but then refusing to continue that payment level after the “trial” period.  Instead, it appears to be nothing more than a short-term money grab.  So, as government officials fret about lack of lender cooperation, foreclosures continue to rise and the real estate market continues to be flooded with short sales and REO’s.  But there is improvement in short sale processing that will help stabilize the market.

Short Sales offer benefits to all parties:  the upside down seller minimizes their credit damage and can negotiate issues of deficiency liability;  the lender gets money now and reasonably gets more than they would through a foreclosure, the buyer gets a home at current market values, and most importantly, one more property is removed from the market thus moving us closer to a real estate recovery.  The sticking point remains lender unwillingness to give up on recourse against the seller/borrower but that has been changing in recent weeks most notably with Bank of America dropping its insistence on recourse is all short sales.  So, while this will not help owners keep their homes, it does help them and the market get on with life and move to a recovery.

Processing the massive amounts of short sale Hardship applications remains a time-consuming effort for lenders. Help may be on the way through new companies such as Mortgage Resolution Services (MResolution.com) which are developing standardized processing and lender negotiation systems that promise to expedite the approval.  As always, borrowers should get independent advice from a knowledgeable attorney as to what their potential judgment and tax liability is before going into any short-sale or letting their property go in foreclosure.

If you have specific questions about your loans, liability, foreclosure, or any legal issue, feel free to contact me at sjbeede@bpelaw.com or call us at (916) 966-2260 for a phone or personal appointment.  We offer a $200 flat fee attorney consultation to enable you to evaluate your judgment and tax risks and to plan a strategy to minimize or even avoid them.  Need help Coping with an Upside Down Loan? Checkout Steve’s audio-seminar and e-book at: http://www.stevebeede.com/copingwithanupsidedownmortgage/.  

In my last Blog article, I wrote about how lenders and collection agencies are falsely claiming that modifying an acquisition loan makes it recourse. Under California Civil Code Sec. 580b, loans made to enable a borrower to acquire (purchase) a 1-4 unit property in which the borrower resides are non-recourse. This means if the lender forecloses, they cannot get a money judgment against the borrower for any deficiency between the amount owed and the foreclosure sale price.  Several lenders are now similarly claiming that a Home Equity Line of Credit (”HELOC”) is recourse even if it was used to purchase the home.  This is a trickier question?

By its nature, a HELOC is a cross between a home loan and a credit card secured by the property. You get the funds up fron to purchase the property like any acquisition home loan. Then, as the HELOC gets paid down, you can draw out money again up to the original amount of the HELOC like you would with a credit card.  On one hand, if it is used to purchase the property, it certainly would appear to have all the characteristics of a purchase money acquisition loan and therefore should be non-recourse. However, since additional credit draws would be in effect new loan amounts not purchase money, these would reasonably be recourse loans.  Lenders would have us believe that this additional loan ability makes the entire HELOC a recourse loan. 

I disagree.

For most home purchasers using two loans, the reason was that the first loan would be 80% and thus mortgage insurance would not be required. The 2nd loan filled in the gap between the 1st loan and the Buyer’s down payment, typically 10-15% of the purchase price.  Since these are both necessary for the Buyer to purchase the home, these are purchase money acquisition debt and would be non-recourse (assuming 1-4 unit, owner-occupied).  For the Buyer, the title of the 2nd loan would not seemingly matter. Whether the lender called it a Home Loan, Home Equity Loan, or Home Equity Line of Credit would not make a difference to a Buyer who needed the loan to purchase the home.

As stated in the 1976 case of Union Bank v Wendland, “The antideficiency statutes indicate a legislative intent to limit strictly the right to recover deficiency judgments….the purpose of that antideficiency statute is to discourage the overvaluing of the security, and the risk of inadequate security because of overvaluation is placed on the purchase money mortgagee.“  Since the lender is placing a value on the property at the time of acquisition and is making a loan secured by the value of the property at that time, the anti-deficiency protection of Sec. 580b should apply to the HELOC just as it would apply to any other acquisition loan. The only difference between the HELOC and any other loan is that the lender allows the borrower to take money back out up to the original secured amount.  And unlike a credit card, the debt is secured. So arguably, even further draws back to the original amount could be non-recourse as well. As the court said in the Union Bank case, “…. the protections of the anti-deficiency statutes can not be avoided because of some clever paper shuffling on the part of the lender. To allow such is a circumvention of the anti-deficiency statutes.”

Can a lender get around this by having a provision in the loan documents stating that the loan will always be recourse?  That is unclear.  Court’s do not excuse a borrower from not reading and understanding their loan documents before they sign.  But, given the very unequal bargaining position of the parties, I expect that the Court’s would lean in favor of application of 580b.  We’ll have to wait and see how these cases turn out, if indeed any such cases are actually filed.

Of course, none of the above is going to stop unethical lenders and collection agencies from threatening and scaring borrowers into paying money on non-recourse debt. 

If you have specific questions about your loans, liability, foreclosure, or any legal issue, feel free to contact me at sjbeede@bpelaw.com or call us at (916) 966-2260 for a phone or personal appointment.  Need help Coping with an Upside Down Loan? Checkout Steve’s audio-seminar and e-book at: http://www.stevebeede.com/copingwithanupsidedownmortgage/.  

On Monday, October 12, 2009, Gov. Schwarzenegger signed Assembly Bill 260 which, effective January 1, 2010, will ban negative amortization loans and preclude mortgage brokers from earning special fees on these high risk loans. According to the Bill’s author, Assemblyman Ted Lieu, the intent is to ban the practices that led to the foreclosure crisis that eventually triggered the recession which we now suffer. This will be good news for some but offers no assistance for the millions who remain at risk of losing their homes under their existing negative amortizing loan contracts. Although lenders will stop making such loans, they have been extremely resistant to cleaning up (modifying) such loans.

As those of you who have followed my Blogs know, the negative-amortization loan was a program offered by lenders to make loans to people who couldn’t qualify for normal fixed rate loans. Because they were marketed on a very low teaser start-rate, a great many gullible borrowers signed up believing the promises that they could later convert to fixed rate or “flip the home” for a profit. Both of these incentives were the unintended consequences of our Government’s desire in the late 1990s to expend home ownership and the American Dream.  The result was that millions of people got loans to buy homes they could not really otherwise afford. When the adjustments started happening and the homes couldn’t be flipped, this expansion of the American Dream quickly became a worldwide nightmare that we’re still dealing with.

The sad reality in all of this is that the lenders were very familiar with the dangers of adjustable rate loans from the problems in the 1980’s but it didn’t stop them from taking the fees up front and setting up this house of cards which had to collapse.  Hopefully this new law will stop such risky practices in the future and compel the lenders to be trustee stewards of their investors’ monies and their borrowers’ expectations.

Possibly this new law will add additional fuel to the legal arguments raised by attorneys seeking to stop foreclosures of these high-risk and now illegal loans. Since it is not retroactive, it does not have any legal effect on existing loans but certainly may influence a judge or jury in determining whether a loan was predatory.

If you have specific questions about your liability, foreclosure, or any legal issue, feel free to contact me at sjbeede@bpelaw.com or call us at (916) 966-2260 for a phone or personal appointment.  Need help Coping with an Upside Down Loan? Checkout Steve’s audio-seminar and e-book at: http://www.stevebeede.com/copingwithanupsidedownmortgage/. 

With the stroke of a pen, Gov. Schwarzenegger signed Senate Bill 94 and put an end to loan modifiers who charge up front fees.  As reported in the Sacramento Bee today, the action comes following massive complaints to the Dept. of Real Estate comcerning loan modifiers who took borrower’s money - up to $4,000 - and then abandoned them. While not condemning all modifiers, the new law applies to every such company that collects up-front fees. 

Earlier this year, State and Federal crackdowns on loan modifiers limited such services to real estate licensees and mandated DRE approved contracts for any up-front fees. However, many simply ignored the restrictions. More significantly, the earlier law excluded attorneys. As a result, law firms quickly filled the gap by collecting up-front fees and then partnering with loan modifiers to do the actual work. The new law puts an end to this.

While protecting the victims of these scams, the intent of the law is to stop abuse of borrowers in trouble. Legitimate loan modifiers can still operate but they cannot get paid until they have performed all of the services promised in their contract with the borrower.  This does not require that payment only be made if the modification is successful.  Borrowers must pay the loan modification firm for the services they provided, even if the firm cannot get the loan modified. 

Furthermore, the modification firms must tell potential clients that they may be able to get the same services for free from government-approved nonprofit mortgage counsellors. You can find these by Googling under such names as “nonprofit mortgage counsellors” or “debt management consultants”. I would expect that with this latest crackdown, getting access to this free help will become much more competitive so don’t wait. Act now and be persistent.

The new law will expire on January 1, 2013 which coincidentally is the expiration date for the Federal Debt Forgiveness Relief Act.  Apparently the concensus in Washington D.C. and in California is that this real estate mess will be cleared up by the end of 2012 so loan modification protection will no longer be an issue.  We’ll hope that they are right.

If you have specific questions about your liability, foreclosure, or any legal issue, feel free to contact me at sjbeede@bpelaw.com or call us at (916) 966-2260 for a phone or personal appointment.  Need help Coping with an Upside Down Loan? Checkout Steve’s audio-seminar and e-book at: http://www.stevebeede.com/copingwithanupsidedownmortgage/. 

A lot of mis-information appears to be circulating on the web concerning how the debt forgiveness tax relief is applied. “Debt Forgiveness” occurs anytime you don’t have to pay back a debt that you owe someone. In today’s world, that most commonly occurs through a foreclosure or a short sale when a lender or lenders are not paid in full. Unless the lender is pursuing a judgment for the deficiency (which is rare), our IRS Code states that the amount not paid, ie: forgiven, is taxable income to the borrower.  In December, 2007, the Federal government passed the Mortgage Forgiveness Debt Relief Act which provided that if you incur debt forgiveness between 2007 and 2012 on your principal residence there will be no tax. Some States have adopted similar provisions to deal with state taxes.  What has become confusing is what is meant by “principal residence”.

Several writers on the web have stated that the test for Principal Residence is that you lived in the property for 2 of the last 5 years. If this were true, then the forgiveness might be available even if the property is now rented out.  So, this is significant.  The “2 out of 5 years” rule is the test for capital gains tax exclusion and is used to determine whether you would have to pay capital gains tax when the property was sold or foreclosed. But this is a different question from debt forgiveness. Capital gains measures the difference between what you paid for the property (taxable basis) and what it sold for (short sale or foreclosure sale). So, if someone has owned their property a long time and refinanced well above their taxable basis, then the “sale” price could result in a capital gain tax to which the 2 out of 5 year rule would apply.  Ambiguities in explanations of the Mortgage Forgiveness Debt Relief Act have led some to conclude that the determination is made by using the capital gains rule on personal residence.  I do not believe that this is accurate. More importantly, this mis-information could leave debtors exposed to debt forgiveness tax.

When it comes to tax questions, it is valuable to examine what the IRS has to say on the issue because if they disagree with what you claim, you’re in for a nasty and costly fight. Luckily, the IRS appears to have answered this question.

IRS Publication 4681 “Cancelled Debts, Foreclosures, Repossessions, and Abandonment” is available for download at http://www.irs.gov/pub/irs-pdf/p4681.pdf. In this Report, the IRS explains how this is treated. At Chapter 1 “Cancelled Debts”, Page 7, the IRS defines what constitutes “Qualified Principal Residence Indebtedness” which is the criteria to avoid the debt. It clearly defines this as “the home where you ordinarily live most of the time. You can have only one principal residence at any one time”. There is nothing whatsoever that provides for a 2 of 5 year definition.

Based upon this, it seems conclusive to me that the IRS will only grant debt forgiveness on the home where you ordinarily live at the time that the debt forgiveness occurs.  Of course, reasonable people could reach different conclusions.  If you are facing a debt forgiveness event, be certain to get competent legal and tax advice.