Short Sales and Deeds in Lieu After the Mortgage Forgiveness Debt Relief Act of 2007
by Richard A. Goodman
Hardly a day goes by without alarming new statistics concerning real estate sales, mortgages and foreclosures. To cite but one, in 2007, there were 84,375 trustee’s sales in California, an all time record. Since the rates on $385 billion of subprime and other nontraditional loans are expected to reset in 2008, nearly as much as in 2007, relief is not expected at any time soon.
Legislative and regulatory proposals abound to stem the tide of foreclosure. At least ten states (not including California) have enacted foreclosure related legislation within the past year. In December, the Federal Reserve proposed rules under the Home Ownership and Equity Protection Act (“HOEPA”) to address the problem. The House of Representatives recently passed the Mortgage Reform and Anti-Predatory Lending Act of 2007 (H.B. 3915) and similar legislation has been passed by the Senate (S.B. 2338).
The harsh reality is that, confronted with loan payments they no longer can afford, owners have only three alternatives short of bankruptcy: giving the lender a deed in lieu of foreclosure; by doing a short sale (i.e., a sale in which the lender agrees to accept less than a full payoff of its loan balance); or walking away from the property and allowing the lender to foreclose. The article will address the differences between these three alternatives and show how the recently enacted Mortgage Forgiveness Debt Relief Act of 2007 affects the tax consequences of each of them.
Major Issues and Considerations
Costs, Timing and Title: In California, a non-judicial foreclosure sale cannot occur until at least three months and twenty-one days after the recordation of a notice of default. If the owner brings a civil action to stop foreclosure or files for bankruptcy, the process can take far longer. In addition, a foreclosure sale costs the lender several thousand dollars, much more if there is litigation. Furthermore, the lender cannot even commence eviction proceedings until after the trustee’s sale. By contrast, if a lender accepts a deed in lieu of foreclosure or approves a short sale, the process can be completed within days rather than months, at minimal cost, and can be conditioned on the owner’s relinquishing possession.
Given the disadvantages of and obstacles to foreclosure, why do so many trustee’s sales occur? One reason is that owners frequently are too dispirited to avoid foreclosure or are unaware that they may be better off attempting to transfer the property through a “deeds in lieu” or a short sale. In addition, lenders frequently require owners to pay all escrow and closing costs as a condition of accepting a deed in lieu. Equally significant, however, is that only by completing a foreclosure sale can junior liens be wiped out. By accepting a “deed in lieu,” the lender takes title to the property subject to all junior liens and encumbrances!
Example 1: Mary Green’s home is worth $500,000 in the current market but is encumbered both by a $500,000 Deed of Trust in favor of Lender A and a $100,000 Deed of Trust in favor of Lender B and she is in default on both loans. She offers a deed in lieu of foreclosure to Lender A, but it declines.
If Lender A were to accept the deed in lieu, it would acquire the property subject to the $100,000 Deed of Trust while if it forecloses, the purchaser at the trustee’s sale will acquire the property free and clear of the $100,000 Deed of Trust.
This is not an insignificant problem since distressed property frequently is encumbered by several deeds of trust. Therefore, any lender willing to consider accepting a deed in lieu invariably requires the issuance of a new title policy to insure that there are no junior liens against the property.
A short sale, like a deed in lieu, can be completed quickly and cheaply. Furthermore, unlike a deed in lieu, the owner rarely is required to pay for escrow and closing costs. However, as with deeds in lieu, the existence of junior liens presents nearly insuperable problems. The reason is that a short sale requires the cooperation of all lenders. The senior lender has little reason to offer any of the proceeds to a junior lender, since all junior liens will be wiped out if the senior lender forecloses. Therefore, the senior lender typically requires that it receive all of the net proceeds of sale or that the junior lienholder be paid only a token amount. If the senior loan has been securitized, the loan securitization agreement may explicitly prohibit the loan servicer from negotiating in this situation. However, if the junior lienholder will receive nothing from a short sale, it has no incentive to cooperate.
Credit Impairment: A foreclosure, which is considered a "major derogatory," typically results in the lowering of one’s FICO credit score by 250-280 points. This can severely hamper someone's ability to get credit for many years. In addition, since many insurance companies now utilize credit histories to evaluate applicants, a foreclosure can later prevent an owner from obtaining life, health or disability insurance.
However, the effect of a major derogatory depends in part upon the circumstances under which it occurred. For example, if the borrower lost his property because of medical bills from a catastrophic illness, a subsequent lender may overlook even a major derogatory. Similarly, a borrower who has been candid and forthcoming with the lender as soon as financial problems occur will be viewed in a far more positive light than one who simply stops making payments, or worse, misleads the lender in any way. Potential lenders are most hostile to borrowers who have defrauded prior lenders or have intentionally delayed foreclosure proceedings in the past.
Although giving a deed in lieu may also have serious credit consequences, these frequently can be ameliorated. For example, an owner can negotiate for the lender, in a deed in lieu transaction to report the loan as “paid” or “settled” rather than as a foreclosure. In addition, loan applications do not always flag such transfers, although the application for conforming loans does request information on deeds in lieu as well as on prior foreclosures.
A short sale usually has significantly less effect than either a foreclosure or a deed in lieu, usually lowering one’s FICO score by 80-100 points. Furthermore, the owner can negotiate, as a condition of a short sale, that, in a short sale, the lender reports its loan as “paid” or “settled” to credit reporting bureaus. In addition, many applications for non-conforming loans do not ask about short sales at all.
Even if a new lender becomes aware that a loan applicant previously completed a short sale, the lender may not treat this as a major derogatory. Many lenders look favorably on a potential borrower who has taken affirmative steps to minimize the prior lender's loss.
Personal liability: As difficult as it is for an owner to face the loss of his entire equity, the possibility that the owner may have personal liability, in addition, is an even greater nightmare. In deciding how to dispose of a distressed property, the owner must understand whether there is any risk of personal liability and, if so, under what circumstances.
In California, "purchase money" loans are automatically non-recourse. A "purchase money" loan is a loan made by a seller to finance the purchase of property of any type or a loan made by a third party lender for the purchase of an owner-occupied, one-to-four unit property. The refinancing of a purchase money loan through the original lender is treated as a purchase money loan up to the amount of the original loan. Any loan other than a purchase money loan is a recourse loan unless it is specifically made non-recourse. This is typically accomplished by including a provision that the lender’s only recourse is to property and that the borrower has no personal liability on the note.
If a loan is non-recourse, either because it is a purchase money loan or because the note contains non-recourse language, the borrower need have no concern about potential personal liability.
But what if the loan is a recourse liability? The first thing to recognize is that even when lenders are entitled to pursue claims for personal liability, they rarely do so because of the expense, delay and uncertainty involved. In order to seek personal liability against the borrower, the lender must utilize a judicial foreclosure rather than a non-judicial foreclosure, which lengthens the foreclosure process by many months. After a decree of foreclosure is obtained, the court must hold a "fair value" hearing to determine if a deficiency judgment will be allowed. And even if a deficiency judgment is awarded, the lender may be unable to collect it. Potential buyers usually are scared away as the prior owner has a one-year right of redemption.
It is no wonder, therefore, most lenders prefer to conduct non-judicial foreclosures even though, by doing so, they must relinquish the possibility of obtaining deficiency judgments. In fact, the only situation in which an owner is likely to face personal liability is where the property is encumbered by a recourse junior lien. If the senior lender forecloses, the holder of the junior lien becomes a "sold out junior lienor." As such, that lender can sue directly on its note and seek personal liability against the borrower. Therefore, an owner whose property is encumbered by a recourse junior lien should take all reasonable steps to avoid a foreclosure of the senior lien. These steps might include agreeing to sign a new, relatively small note in favor of an existing lender in order to overcome the lender’s reluctance to agree to a short sale.
Lender Cooperation: If a short sale is contemplated, the lender should be consulted as soon as possible, as lenders typically require detailed financial information from the borrower as well as the listing and purchase documentation.
The most important factor influencing a lender's decision is whether the lender is likely to recoup more by foreclosing and selling the property as an REO or by accepting the short sale payoff. This decision is usually influenced by the following considerations:
• Has the property been fairly exposed to the market?
• Are the real estate brokers willing to accept a reduced commission?
• How quickly can the short sale be consummated and the loan payoff made?
• How much expense would the lender incur in a non-judicial foreclosure?
• Would the lender undertake significant toxic or other liability risks by
acquiring the property?
Tax Considerations: If a loan is non-recourse, the tax consequences of a short sale, a deed in lieu and a foreclosure are identical: the taxpayer is treated as having taxable gain to the extent that the loan balance exceeds the taxpayer's adjusted basis in the property. This gain generally is treated as capital gain.
Example 2: In 2004, John Doe purchases Blackacre, a vacation home, for $500,000, making a $50,000 down payment and obtaining a purchase money loan from Lender A for $450,000. In 2005, Doe refinances with a $600,000 loan from Lender A, which is secured by a non-recourse deed of trust. In 2006, Doe sells Blackacre for $550,000 in a short sale, paying all of the net proceeds to Lender A.
The $450,000 loan is non-recourse because it is used for the acquisition of Doe’s principal residence. The $600,000 is non-recourse by its terms. In 2006, Doe has a capital gain of $100,000 (i.e., $600,000-$500,000). Similarly, Doe would have had a $100,000 capital gain if he gave a deed in lieu to Lender A or if Lender A foreclosed.
Of course, if the property is the owner’s principal residence, all or part of the gain may be excluded.
Example 3: The facts are the same as in Example 2 except that Blackacre is Doe’s principal residence.
If Doe has owned and resided in Blackacre for at least two years as of the date of the short sale (or deed in lieu or foreclosure) and otherwise meets the requirements of IRC section 121, he will be entitled to an exclusion of up to $250,000 of gain if he is unmarried, $500,000 if he is married (the “Personal Residence Exclusion”).
Prior to 2007, the rule was that if the loan is recourse, an owner will have cancellation of debt income (“COD”) to the extent that the loan balance exceeds the fair market value of the property, regardless of how he disposes of the property. COD income is not eligible for the Personal Residence Exclusion and is taxable as ordinary income, not as capital gain!
Example 4: The facts are the same as in Example 3 except that the refinance in 2005 is through Lender B and is not specifically made non-recourse.
Because the purchase money loan is not refinanced through the original lender, the $600,000 loan is recourse. Therefore, on his 2006 tax return, Doe must report a capital gain of $50,000 (i.e., $550,000-500,000) unless the Personal Residence Exclusion applies. Doe also must report $50,000 of COD income (i.e., $600,000-$550,000).
In theory, the result was the same whether a recourse loan was cancelled through a foreclosure, the giving of a deed in lieu or a short sale. However, in either a foreclosure or a deed in lieu, the seller can contend, with the support of expert appraisals, that the fair market value of the property is at least as great as the loan balance. In a short sale, by contrast, the seller is stuck with the sale price as establishing the property’s fair market value.
The Mortgage Forgiveness Debt Relief Act of 2007 (the “Act”), signed by President Bush on December 20, 2007, provides that certain debt cancellation is not treated as COD income. The Act applies only to “Qualified Personal Residence Indebtedness” (“QPRI”). QPRI is defined as indebtedness incurred in the acquisition of the taxpayer’s principal residence (not exceeding $2,000,000) or the refinancing of that loan up to its initial amount. Thus, a refinancing loan through a different lender is treated as QPRI even though it is a recourse loan. To the extent that COD income is excluded under the Act, the owner’s basis in the property is reduced. The Act applies to QPRI discharged after 2006 and before 2010.
Example 5: The facts are the same as in Example 4 except that the short sale occurs in 2007 rather than in 2006.
The $600,000 loan is QPRI under the Act. Therefore, Doe does not have COD income. However, he has a capital gain of $100,000 (i.e., $550,000-$450,000), unless the Personal Residence Exclusion Applies.
The computations become more complex if some but not all of an owner’s refinancing debt is treated as QPRI.
Example 6: Ray and Janet Burke purchase Greenacre, their personal residence, in 2006. The purchase price is $1,000,000, payable $100,000 down, with a $900,000 loan from Lender X. In 2007, they obtain a $1,100,000 refinancing loan from Lender Y. In 2008, they complete a short sale of Greenacre for $750,000.
Although the $1,100,000 loan is recourse, $900,000 of it is treated as QPRI and the $200,000 balance is treated as COD, which the Burkes must report in 2008 as ordinary income. Since the Burkes have been relieved of $150,000 of COD income (i.e., $900,000-$750,000), their basis in Greenacre is reduced by $150,000 to $850,000 (i.e., $1,000,000 basis-$150,000 basis reduction). Therefore, in addition to reporting, as ordinary income, the $200,000 COD income, the Burkes have a non-deductible loss of $100,000 (i.e., $750,000 sales price-$850,000 adjusted basis).
From the standpoint of cost, credit impairment and personal liability, a short sale usually is preferable to a deed in lieu and both generally are advantageous as compared with a foreclosure. However, if a property is encumbered by a junior lien, the holder of the senior lien is unlikely to approve either a deed in lieu or a short sale. If the junior lien is recourse, avoiding foreclosure becomes all the more important since foreclosure of the senior lien may well expose the owner to personal liability on the junior lien. From a tax standpoint, some owners will be relieved of COD income under the Act. However, in situations where the Act does not apply (such as vacation homes and investment property), the tax consequences of a short sale will continue to be harsher than those of either a deed in lieu or of a foreclosure.
Information is compliments of Placer Title Company
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