Legal/Tax Issues in Short Sales/Foreclosures

Lately, much has been written and talked about in the news regarding real property short sales and foreclosures.  Federal and state law have also been changing in an attempt to assist homeowners who find themselves "under water" and burdened with excessive mortgage debt.  When faced with a foreclosure, a homeowner has various options and may be assisted by advice from an attorney.

A purchase-money borrower (when the deed of trust secures the purchase-money loan, as opposed to a refinance) in particular should consider these different options because in California, generally, if the borrower defaults, the lender's sole recourse will be to foreclose on the property.

The first option to consider is obtaining a loan modification or a refinancing of the loan on more favorable terms.  A modification alters the terms of the existing loan.  However, a borrower should not lightly re-finance a purchase-money loan, since the new loan may not be considered a purchase-money loan, and the borrower may become exposed to personal liability for any "deficiency" owed under the refinanced loan.

Another option, is to surrender the deed in lieu of foreclosure (i.e., turn over title to the lender, sparing the necessity of foreclosure proceedings).  This requires negotiations with the lender, or perhaps simultaneous negotiations with more than one lender.  The success and terms of the endeavor may depend on whether the loan or loans are purchase-money loans.

Another option is to "walk-away" or simply allow the foreclosure process to proceed.

Still another option is to attempt to negotiate a short-sale.  A short-sale is the sale of the property for less than is owed on the loan, done with the lender's approval, so that the lender removes its lien against the property upon the sale and releases the borrower from further liability.   Short-sales require that the lender or lenders to agree in advance to the arrangement and will require some negotiation to protect the seller.

Each of these options may have legal, credit and tax consequences.  For example, any forgiveness of debt may be treated as gross income by the IRS.   Therefore, if a lender forgives a certain amount of debt to a borrower, the amount may become an unanticipated tax liability.  Federal law gives taxpayers some relief for forgiven debt on a primary residence discharged after January 1, 2007 and prior to January 1, 2013.   California law also allows some tax debt relief under similar circumstances but currently applies to property sold after January 1, 2007 and prior to January 1, 2009.  A current bill to conform California law to Federal law was pending in the legislature but has not yet been signed into law.   San Francisco Chronicle article.

Further, a foreclosure, short sale, or deed-in-lieu of foreclosure will each have some effect on the borrower's credit report.  For example, information from Fannie Mae is contained here.    (Scroll down to review:  Ann. 08-16, June 25, 2008, "Bankruptcy, Foreclosure, and Conversion of Principal Residence Policy Changes; and Revised Property Value Representation and Warranty Requirements.")

Before deciding which alternative to pursue, it is always necessary to consider the possibility of a deficiency judgment.   "Walking away", or allowing a foreclosure to occur, might be a poor option if the loan is not a purchase-money loan.   Where the loan is not a purchase-money loan, the lender can seek a "deficiency judgment" against the borrower for the difference between the foreclosure proceeds and the final arrears owed under the loan.

The Obama Administration has also put into place programs under which distressed borrowers can qualify for loan modifications and refinancing of their existing loans.   A loan can be modified by one or more of the following means: (1) a lowering of the interest rate; (2) a reduction in the amount of loan principal; and/or (3) an extension of the term of loan, possibly with periods of forbearance on collecting the loan.    Moreover, California law now requires lenders to satisfy additional procedures before proceeding with a foreclosure.

Always be sure to consult your tax advisor and/or attorney.