Feb122009

The Financial Implications of Short-Sales and Foreclosures

Below is the post in its entirety:short_sale

The California Foreclosure Rules or “So What Happens If I Let My California House Go Back To The Bank?”

I get this question a lot.  The answer is, IT DEPENDS.   That’s a slippery lawyer’s response (someone called me that yesterday) but the outcome in your situation could be

1.                  You still owe the bank a big slug of money;

2.                  You have a big income tax bill with no cash to pay it;

3.                  You owe the bank a big slug of money and you have a big tax bill ; or

4.                  You owe the bank nothing and you do not have a tax bill.

Everyone wants to be the last case.  A lot of my clients show up to my office as the third case.  The good news is most people can be the last case, but only IF THEY PLAN CAREFULLY!!!

This brings me to Jim Cramer.  I like Cramer because he brings raw institutional investor insights to the masses. He tells the brutal truth (as he sees it) and I respect that.  But I was screaming at the plasma screen when he cavalierly advised his fans to “walk away” from their houses.   I don’t fault his economics:  if your house is sucking all your money from you, why throw good money after bad on it?  But you can really hurt yourself financially if you do not “walk away” carefully.

So I have set out below the Califronia rules that you need to take into account when you let your house go. They are really complicated and are too complicated for you to figure out on your own so GET PROFESSIONAL ADVICE BEFORE YOU DO SOMETHING STUPID.

THE CALIFORNIA FORECLOSURE RULES

1.                  THE PURCHASE MONEY RULE:

In California, a lender who loaned you money to BUY your home, which you ORIGINALLY moved into as your primary residence, cannot do anything other than foreclose.  This means if the foreclosure sale does not pay all “purchase money” loans, those lenders cannot sue you for the unpaid balance.  Most importantly, this includes second mortgages used in many 80/20 100% financing deals.   If you REFINANCED any of these loans, or paid down purchase money HELOC and drew down on it again, this rule does not apply.

2.                  THE ONE ACTION RULE:

In California, a mortgage lender can only take one action against you:  A non-judicial foreclosure, or a judicial foreclosure.  The result of a non-judicial foreclosure is just like the PURCHASE MONEY RULE, a lender can only sell the property and pay the loan.  If the sale does not pay the mortgage, the foreclosing lender cannot get the unpaid balance from you.  However, the lender can get the balance from you in a judicial foreclosure. The good news is judicial foreclosures are too uncertain and costly for lenders that they are almost non-existent.  BUT, (pay attention, this is important) if a junior lender’s security interest is wiped out by a senior mortgage foreclosure, the junior lender can obtain a deficiency judgment for their unpaid balance because they have not had their ONE ACTION against you yet (subject to the PURCHASE MONEY rule of course).  This situation is very common these days for that second mortgage you used to remodel the kitchen and bathroom, or bought that Escalade, or refined a previous second mortgage.

3.                  THE CANCELLATION OF DEBT RULE:

Both the IRS and California tax you for the amount of debt that is CANCELLED in any given tax year.  Debt is cancelled only when a lender has given up on its right to collect the debt or they are barred by law from collecting the debt (think PURCHASE MONEY & ONE ACTION rules).  HOWEVER, if the debt cancelled was a “Purchase Money” loan (see above) the debt cancelled is treated as a sale of your residence, subject to normal homeowner exclusions.  This is because the loan is deemed to be non-recourse and therefore nothing has been cancelled.

4.                  THE BANKRUPTCY & INSOLVENCY EXCEPTION.

Both the IRS and California exclude cancelled debt from your income to the extent the debt was CANCELLED in bankruptcy and you were insolvent; BUT ONLY TO THE EXTENT OF YOUR INSOLVENCY!!!!   You are insolvent when your debts exceed your assets.  Assets include IRA and pensions.  GET A CPA TO HELP YOU HERE. YOU WILL NEED IT!  DON’T BE STUPID AND TRY TO FIGURE THIS OUT YOURSELF!

5.                  THE FIRST ACTION RULE.

Not to be confused with the ONE ACTION RULE, this rule says a secured creditor must seek to recover the secured property before suing you for non-payment.  This means a second or third mortgage will have to wait until the first or senior mortgages foreclose before they can sue you for a deficiency.

So, you think you know the rules?  Let’s try a few examples and see how you do.  Answers & explanations are below.

Example 1:  Mike borrowed an $800k first and a $200k second loans to buy a beach condo he stays at on the weekends and rents out occasionally.  The first foreclosed (non-judicial) and paid off only $750k of the first loan.  The second was wiped out.  What happens?

A.                 Mike walks away without any debt to the first or second loans because it was “purchase money” debt;

B.                 Mike has income from the cancellation of debt of $50k on the first and all of the second;

C.                 Mike owes the second the entire balance and has $50k cancellation of debt on the first mortgage;

D.                 A&B

E.                  B&C

F.                  Mike can’t surf so it does not matter.

Example 2:  Mike got a $200k first loan to buy his house and later took a $400k second to add a go-cart track and skate board ramp.  The SECOND foreclosed (non-judicial) and just paid off the first loan.  The second was wiped out.  What happens?

  1. Mike walks away without any liability to the first or second loans.
  2. Mike has income from the cancellation of debt on all of the second loan;
  3. Mike has no cancellation of debt income;
  4. A&B
  5. B&C
  6. Mike can’t surf so it does not matter.

Example 3:  Mike got an $800k first loan and $200k second to buy his home.  The second was a HELOC that he paid off then borrowed against to buy land in front of a great surf break.  The first foreclosed (non-judicial) and just paid off the $750k of the first loan.  The second was wiped out.  What happens?

  1. Mike walks away without any debt to the first or second loans.
  2. Mike has income from the cancellation of debt of the second loan;
  3. Mike has no cancellation of debt income;
  4. A&B;
  5. B&C
  6. Mike can’t surf so it does not matter.

Example 4:  Same example as three, expect that  his first mortgage was refinanced and, just prior to the foreclosure, Mike had (in addition to his house debts) $10,000 in cash and no other debts.  What happens?

  1. Mike is taxable on the entire $50k CANCELLATION of debt from the first loan because he is not insolvent.
  2. Mike is taxable on $10k of his CANCELLED debt;
  3. Mike has no CANCELLATION of debt income;
  4. Mike can’t surf so it does not matter.

Example 5:  Mike buys an investment property with a $500,000 first mortgage and a $200,000 second mortgage.  Mike gets in an argument with the second mortgage company because they say he cannot surf.  So Mike stops paying the second mortgage when the property is worth less than the balance of the first mortgage. What happens?

  1. The second mortgage forecloses and Mike has CANCELLATION of debt income.
  2. The second mortgage sues Mike for non-payment;
  3. The first mortgage company sues Mike for default;
  4. Mike sues the second mortgage company for slander;
  5. None of the above.

ANSWERS

1.  C & F are correct.  The loans are “purchase money” but because Mike did not move into the condo and make it his home when he got the loan, the purchase money rule does not apply (WARNING Ask your attorney about the rare VENDOR RULE).  The second can sue for the balance because it has not yet taken its ONE ACTION and is thus not CANCELLED.  The first is $50k short and it cannot sue Mike for the balance because it took its ONE action so the debt is now CANCELLED and is taxable income.  F is always true.

2.  D & F are correct.  The first loan was paid and thus there is neither deficiency nor cancellation of debt.  The second loan was not a “purchase money” because the loan (although put to great use) was not used to buy the house.  BUT, the second foreclosed so it used its ONE ACTION and cannot get a deficiency.   Because the second cannot get a deficiency, the debt is now cancelled and is now taxable income.  F is always true.

3.  Only F is correct.  The first loan was used to buy the home and it foreclosed so both the ONE ACTION and PURCHASE MONEY rules apply to prevent the first from getting a deficiency for the $50k.  But $50k of the balance is CANCELLED, BUT it was non-recourse PURCAHSE MONEY debt so it is treated as a sale of his home for $800k, subject to the home sale exclusion rules.  The second was not a purchase money loan because the second set of loan proceeds were not used to buy the home.  The second did not take an action so it can still sue Mike for a deficiency. Because the second can still sue Mike, it is not CANCELLED and thus not taxable income.  F is always true.

4.  C and D are correct.  Mike has CANCELLATION OF DEBT income because his first mortgage is not purchase money but the ONE ACTION RULE prevents the lender from recovering the $10,000 deficiency.  However, Mike has $760k in assets (house + cash) and $1 million in debt so his liabilities are in excess of his assets and thus his income is excluded.  Had mike just had an $800k first mortgage, he would have been taxable on $10,000 of the debt because without the forgiven debt, he would have $10k in net assets.  So the tax is excluded only TO THE EXTENT OF THE INSOLVENCY.  D is always true.

5.  E is correct.  The second mortgage is in default and can bring a foreclosure action against Mike but it cannot sue Mike because the FIRST ACTION RULE says they must move to recover the secured property first.  They will not do this because the value of the property is worth less than the first mortgage.  The first mortgage is still current so it cannot take any action against Mike.  Truth is always a defense against slander so Mike cannot sue for slander.

There were several items I found interesting:

  • If you used a HELOC as a purchase money mortgage, it is non-recourse, if you did not tap this HELOC later. Everyone who used a HELOC to buy, then went to the housing ATM, gave up their non-recourse protections.
  • If you never lived in the property as a primary residence, the loans are recourse. As one might imagine, this is an area of enormous cheating and tax fraud. Nobody is going to admit that they never lived there as a primary residence. In fact, most will point to the lie they told on their mortgage application (everyone claims a property as their primary residence to get a better rate) as proof that they did live there. I spoke with someone who was doing a short sale, and his financial advisor told him to lie. I guess everyone figures they will not get caught.
  • A second mortgage who was wiped out by the foreclosure on the first mortgage can still take action against the borrower. Most don’t bother, but they have the right.
  • Just because the lender isn’t calling you trying to collect doesn’t mean they cannot or will not in the future. If the debt is classified as recourse, the lender will either give you a 1099 for the forgiveness of debt, or they will try to collect (or they will sell the bad debt to someone else who will try to collect.)
  • In order to establish insolvency, you must prove you are broke. The assets you have in your ERISA protected retirement accounts must be counted. This is a strange exception because the IRS cannot get a judgment against your retirement accounts, but they will count these assets when calculating tax on forgiven debt. This could easily create a situation where a borrower has to declare bankruptcy to wipe out the tax burden or pay it out of their retirement savings.

I wrote about these issues in The Great Housing Bubble. I did not go into this level of detail (partly because I didn’t want to be accused of giving legal advice). I hope this post provides some clarity on these issues.