Liability Under California Law And Tax Issues Relating To Foreclosure And Short Sales

I. LIABILITY ISSUES

A. Recourse vs. Non-recourse The first issue in determining whether or not there is personal liability is whether the loan is recourse or non-recourse. Putting aside the potential for fraud in the loan application, there would not be personal liability for a non-recourse loan but may or may not be for a recourse loan.

1. Purchase Money Mortgages Under California Civil Code of Procedure 580b, there is no personal liability (i.e. the right to a deficiency judgment) following the sale of real property under the following:

a. For the purchaser's failure to complete his contract of sale,

b. For purchase-money mortgages given to the vendor, or,

c. Under deeds of trust or mortgages that are given to a lender to purchase a residence of up to four units in which the borrower resides.

2. Refinancing

a. In general, where you refinance a purchase money mortgage, you do not retain this same protection.

b. However for the refinance of a purchase money mortgage occurring after January 1, 2013 where no principal from the refinance is used for payment of other obligations or taken out as cash, the refinanced mortgage retains its non-recourse character for which there is no personal liability.

3. Equity Lines of Credit Generally, unless the line of credit was used in the initial purchase of the property, it does not offer this same protection.

B. Non Judicial Foreclosure Under Code of Civil Procedure(CCP) section 580d , there is no deficiency allowable following a sale under the non judicial power of sale contained in a deed of trust.

C. Judicial Foreclosure Where not protected by CCP section 580b a creditor can seek a judicial foreclosure of the property which could allow a deficiency judgment. This is rarely done with residential mortgages as it is an expensive and lengthly process with the potential that the homeowner could file bankruptcy at the end and discharge the deficiency judgment.

D. Sold Out Junior Lien Holder In the event a senior lender completes a foreclosure in which a junior lien holder is not paid, the junior lien holder, now having no security for its debt can, unless it were a purchase money mortgage, sue the homeowner for breach of contract for the amount still owned under its debt.

E. One Action Rule Under CCP section 726(a) , a creditor is afforded one form of action for the recovery of any debt secured by a mortgage on real property. So long as the creditor is secured the creditor is required to proceed against the security. If the creditor forecloses under the power of sale contained in a deed of trust no deficiency can be obtained. If a deficiency is not barred by 580b the creditor would have to proceed under a judicial foreclose and seek the deficiency in that same action within a short time frame as set out in the statute.

1. Fraud Under CCP §726(f) where there was fraud in the loan transaction and the fraudulent conduct of the borrower induced the original lender to make the loan, a lender is not barred by the one action rule from foreclosing and then may bring in action for recovery of damages including punitive damages not to exceed 50% of the actual damages.

a. Owner Occupier Small loan Exception This right to seek damages for fraud following foreclosure does not apply under CCP §726(g) to loans secured by single family, owner occupied residential real property when the property is actually occupied by the borrower as represented to the lender in order to obtain the loan and the loan is for an amount equal to or less than $150,000 as adjusted annually commencing on January 1, 1987, to the Consumer Price Index

II. TAX ISSUES

A. Recourse vs. Non-recourse Just as in the discussion for the liability, the tax treatment for a foreclosure or short sale differs for a non-recourse obligation and a recourse obligation.

1. Recourse Where the loan was a recourse obligation the transaction is bifurcated into a sale at the fair market value of the property which would result in a capital gain or loss and relief from indebtedness equal to the difference between the outstanding balance of the loan and the fair market value.

2. Non-recourse In a non-recourse situation the transaction is treated as a sale or exchange at the full value of the outstanding loans notwithstanding the fair market value of the property.

B. Capital Gain There are no provisions available under IRC§108 to exclude any capital gain generated by the sale. However, under general tax statutes, the capital gain can be offset from other capital losses. Presumably there would be a capital loss equal to the difference between the adjusted basis and fair market value in the case of recourse financing or the greater of its fair market value or the outstanding balance of the loans in the event of non-recourse financing which loss should offset the gain. If the property is a personal residence the loss would not be deductible but part or all of the gain may be excludable if the homeowner qualifies for the $250,000-$500,000 exclusion from capital gains upon the sale of a personal residence under IRC § 121.

C. Relief From Indebtedness Absent an exception, relief from indebtedness is taxable under IRC§ 61(a)(12) as ordinary income.

1. Internal Revenue Code Section 108. IRC §108 provides that relief from indebtedness can be excluded from income where:

a. The relief takes place in a bankruptcy proceeding, or ,

b. Where the taxpayer is insolvent prior to when the relief from indebtedness occurs but only to the extent of the insolvency. However there are complicated provisions affecting the taxpayer's basis in properties and the taxpayer's tax attributes where relief from indebtedness income is excluded.

2. Mortgage Protection Act of 2007. This legislation amending IRC §108 allows taxpayers who meet its requirements to exclude relief from indebtedness income.

a. Effective Dates This relief is only available for indebtedness discharged on or after January 1, 2007 and before January 1, 2015

b. California Law: In April 2010, California conformed in most, but not all, respects to the Federal Law retroactive to 2007 and effective through January 1, 2013. However, California has not yet extended this protection for transactions occurring after January 1, 2013.

c. Basis Adjustment . If the taxpayer retains the property its basis is reduced by the amount of relief from indebtedness excluded.

d. Exclusion Limits . The maximum amount which can be excluded is $2,000,000 for married taxpayers and $1,000,000 for single taxpayers.

e. Type of Property This relief is limited to the taxpayer's principal residence and would not include a vacation home.

f. Type of Indebtedness The indebtedness must be recourse and incurred to purchase or improve the property (acquisition indebtedness). The typical purchase money mortgage in California is non-recourse and would not qualify for this relief.

g. Refinance . Acquisition indebtedness includes refinancing proceeds to extent proceeds either refinance acquisition indebtedness or are used to improve the property.

III. STRATEGIES

A. Non-fraud Situations Where there is no fraud involved in the loan applications or in any other aspect of the procurement of the loans the following strategies should be considered.

1. Short Sale If non-recourse, the borrower will not face liability issues but could incur capital gain where the property is worth less than the mortgage. A short sale could avoid the negative credit impact of foreclosure and should be considered. Otherwise, foreclosure generally will result in the same liability/ tax result.

2. Equity Second Mortgage Under Water Presumably the second is not purchase money and there would be a potential liability should the first foreclose and the second not be paid off. Since the second cannot proceed against the homeowner before exhausting the security a strategy might be to keep the first current and not pay the second whose options would be to eventually foreclose non-judicially and give up any right to a deficiency or to judicially foreclose and seek a deficiency judgment.

3. Bankruptcy. Assuming the homeowner otherwise qualifies to file and would and benefit from bankruptcy (i.e. the homeowner can satisfy the means test for Chapter 7 and does not have substantial non-exempt assets), the filing of bankruptcy would offer relief from both the liability for the unpaid mortgages and for any relief from indebtedness income generated by the foreclosure on the property. Bankruptcy will not give relief from the potential capital gain generated by the foreclosure. An additional benefit of bankruptcy where there could potentially be fraud issues in the procurement of the loan, is that the filing of bankruptcy significantly shortens the statute of limitations to approximately three months from the filing of the bankruptcy for a creditor to file an adversary proceeding in the bankruptcy court.