URGENT – IRS and FTB Update Regarding Short Sales

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The California Association of Realtors yesterday issued a press release stating that, as a result of recent rulings by the Internal Revenue Service and California Franchise Tax Board, mortgage debt forgiven in a California short sale is no longer taxable as income.

This is huge news, since the tax exemption for this income tax was scheduled to expire on December 31, 2013 when the Mortgage Debt Relief Act expired.  Without these rulings from IRS and FTB, California homeowners whose short sales did not close by year end were facing potentially enormous tax liability.

The IRS ruling was contained in a letter to Senator Barbara Boxer.  The FTB ruling was in a letter obtained the C.A.R. from Board of Equalization member George Runner.

The rationale for the rulings appears to be that debt forgiven in a short sale is not considered “recourse” debt under California law, thus exempting it from taxation.

The C.A.R. press release does not state whether this ruling also will apply to short sale of non-primary residences in California, or if it is limited to only certain types of mortgage debt.  I have requested my tax experts to review the actual letters and updated regulations to clarify these issues; I will provide that response immediately upon receipt.

At this point, it appears that similar protections will be extended to homeowners whose properties are foreclosed after December 31, 2013 where the debt forgiven was used to buy, build, or make substantial improvements to a primary residence.  It does not appear these protections will apply to “deed in lieu” transactions.

California homeowners with pending short sales may breathe a sigh of relief.  For these folks, it would appear that Christmas came a few weeks early this year.

SB 30 Update

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Just a quick update on the status of the California “debt forgiveness” tax measure:

As previously reported, the California Senate passed the California Association of Realtors-sponsored tax relief bill without a single “no” vote on June 20.  The bill was then referred to the state Assembly, where it continues to languish.  A hearing on the bill is scheduled before the Assembly’s Revenue and Taxation committee on August 12, 2013.

As also reported, the bill as currently drafted remains linked to Senate Bill 391, which imposes new fees for the recording of real estate documents, and which SB 30-sponsor CAR opposes.  This means SB 30 will fail unless SB 391 also passes, or unless the two bills are unlinked.  SB 391 is also scheduled for a hearing on August 12, 2013 before the Assembly’s Housing & Community Committee.

Stay tuned….

 

SB 30 Still Mired in Legislative Limbo

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Hard to believe it’s now been more than 6 months since Senator Ron Calderon introduced Senate Bill 30 on December 3, 2012.  The bill passed an important hurdle late last week following passage by the Senate (36-0), and has now been to the Assembly’s Revenue and Taxation Committee.

A  recent amendment to the bill has created significant controversy and resulted in loss of support from its initial sponsor and strongest supporter, the California Association of Realtors.

Specifically, the bill as currently drafted now requires the passage of a separate piece of legislation, Senate Bill 391, also passes: “This act shall become operative only if Senate Bill 391 of the 2013–14 Regular Session is enacted and takes effect.”

SB 391 would establish a $75 per document recording tax to fund an affordable housing trust fund.  C.A.R., according to a recent press release, is opposing SB 391 “because it unfairly adds to the cost of recording real estate documents.”

It remains to be seen whether the State Assembly will further amend SB 30, including, possibly, the removal of the SB 391 link.  Any differences between the Senate and Assembly versions will be resolved in a concurrence committee made up of members of each house. The Governor will have thirty days to sign or veto the bill.

Meanwhile, sellers of underwater properties, or owners facing foreclosure, remain uncertain whether, and to what extent, they may face state tax consequences related to the transfer of their homes.  Certainly, a prompt resolution of the legislative impasse would bring welcome and needed clarity to a currently muddied real estate market.

SB 30 Passes Major Milestone

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Senate Bill 30, the bill to reinstate the California state tax exemption for cancelled or forgiven mortgage debt of qualified homeowners, passed a major hurdle on May 23, 2012, when the legislation was passed out of the Senate Appropriations Committee by a 7-0 vote.

While the bill still requires a vote by the full senate, as well as Governor Brown’s signature, the likelihood of ultimate passage of the bill seems much higher following the unanimous approval by this very key committee.

As background, the previous tax exemption expired on December 31, 2012, and has remained mired in the legislative weeds while the governor and legislature battle over other state funding priorities.  The result has been significant uncertainty in the “distressed property” market, with real estate professionals and “underwater” homeowners lacking clarity on whether there would be state income tax consequences following a short sale, foreclosure, deed in lieu of foreclosure, or other mortgage debt cancellation event.

(The federal tax exemption for qualified homeowners was renewed in February 2013, and remains in place through the end of this year.)

If passed, the bill will amend Section 17144.5 of the California Revenue and Taxation Code, to provide for a one-year extension of the state tax exemption for certain cancelled mortgage debt.  It is not expected the exemption will be renewed again, so that any homeowner seeking its protection must conclude her/his transaction by December 31, 2013.  Since a short sale can take several months to close, it is recommended that individuals considering this option immediately consult with a qualified real estate professional, as well as seeking advice from experienced attorney and tax adviser.

SB 458/931 Not Impacted by Debt Forgiveness Relief Act Expiration

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No New News of Possible Extension of Mortgage Debt Relief Act

I continue to receive daily inquiries from homeowners and real estate professionals regarding the pending December 31st expiration of the Mortgage Debt Relief Act.  Unfortunately, the matter remains mired in the highly politicized negotiations over the “fiscal cliff.”  While I remain hopeful that the necessary parties will set aside their differences for the benefit of distressed homeowners, that hope is tempered by skepticism based on the lack of progress in the negotiations.

Meanwhile, I urge all affected individuals to contact their congressional and senate representatives to let them know where you stand.  And keep your fingers (and toes) crossed.

My purpose is writing this blog is to address a separate but related issue about which I’ve also received numerous questions.  Specifically, are California’s SB 458/931 threatened by the potential expiration of the Act?  The short answer is “no.”

Don’t Confuse California’s Short Sale “Anti-Deficiency” Protections with the Taxability of Forgiven Debt

California Senate Bills 458 and 931 were enacted in 2011 and are now found in Section 580e of the Code of Civil Procedure.  These laws say that a lender who agrees to a short sale is barred from collecting any portion of the mortgage debt not paid from the proceeds of sale.  In other words, the “deficiency” is deemed “forgiven” as a matter of law; thus the term “anti-deficiency” protection.

Before Section 580e, lenders frequently approved short sales only on the condition that the seller/borrower agreed to repay some portion of the loan deficiency.  This is no longer allowed.  More importantly, there is no “expiration date” to this California statute.  It will remain in effect unless and until repealed by the legislature with the consent of the governor.  That is extremely unlikely.

In summary, no matter what happens with the Mortgage Debt Relief Act, mortgage holders whose lenders approve a short sale of their California property will remain protected by the state’s “anti-deficiency” statutes; they will not have to repay any portion of the unpaid, forgiven loan balance.

Impact of Expiration of Act on California Short Sales

In contrast, expiration of the Mortgage Debt Relief Act will remove many of the protections that qualified homeowners have had since 2007 for the tax consequences of forgiven mortgage debt.  In other words, the IRS will tax as income any portion of the home loan not repaid to the lenders from the proceeds of the short sale.  (As stated in earlier articles, there are other possible tax exemptions applicable to this “income”; however, far fewer property owners will qualify for these other protections.)

Expiration of the federal Act will trigger expiration of California’s related tax protection.  That is, the law passed in California to protect homeowners from the state income tax liability for forgiven debt also expires on December 31, 2012.

There is no guarantee that an extension of the federal exemption will automatically result in an extension of the California exemption.  For that reason, it is also important to contact your representatives in Sacramento to urge extending the state tax protection.

If you are uncertain regarding the impact of these matters on your situation, please contact qualified legal and tax professionals without delay.


 

“Simon Rule” Gutted by New Court Decision

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The so-called “Simon Rule”, among the most potent weapons available to distressed homeowners in negotiating short sales, and protecting themselves from financial liability following foreclosure, has been significantly weakened as a result of a new California court of appeals decision.  That decision, Cadlerock Joint Venture, LP v. Lobel (2012) 203 Cal.App.4th 1531, will change the landscape to the detriment of many struggling California mortgage holders.

How Does This Impact Homeowners Considering a Short-Sale?

Cadlerock now requires a court to look at who owns the loans at the time of the foreclosure by the senior lienor.  If the senior lienor has assigned/sold its junior lien to a third party prior to the foreclosure, that third party will now be able to sue the homeowner for the full amount of the junior loan after the foreclosure.  To summarize, following Cadlerock, in most situations the homeowner will lose the home and also have to repay the balance of the non-purchase money second loan.  (The court left a small amount of “wiggle room” for cases where the senior lienor assigns/sells its junior lien after the foreclosure.  There, Simon will still apply.)

Simon Rule Background

As discussed in previous articles, for the last twenty years many Californians with non-purchase money second loans have been able to protect themselves from claims brought by certain “junior” lenders after a foreclosure by the “senior” lender.  This protection originated in a landmark case called Simon v. Bank of America (1992) 4 Cal.App.4th 1537.

The Simon decision created an exception to the old rule that applies where a homeowner has two separate loans on a single property, and where the first mortgage holder (aka the “senior lienor”) forecloses on the property.  Before Simon, the second loan (aka the “junior lienor”) could collect the balance still owing on that loan after the senior foreclosed (and so long as the second loan was not a “purchase money” loan; i.e., part of the loan “package” used to buy the house).  (“Purchase money” second loans were, and still are, barred from collection under a separate rule not discussed here.)

What Simon said was that where the first and second loans were issued by the same bank (in that case, Bank of America), the bank could not collect on its second loan after foreclosing on its first loan; thus, the “Simon Rule”.  An equally important part of the rule was that a bank could not avoid this restriction by “assigning”, or selling, its second loan to another bank or investor.  In other words, courts would look to who owned the loans when they were issued.  If the same bank issued the two loans, the “Simon Rule” would apply.

In recent years, Simon became an invaluable tool in negotiating short sales involving non-purchase money second loans.  (See my January 2012 blog post, Playing the Simon Card in Short Sale Negotiations.)  Cadlerock now renders that tool virtually useless.

All homeowners considering short sales should consult with competent legal counsel to determine the impact of Cadlerock on their situation.  Failure to do so may result in enormous financial consequences and long-term hardship.

Important HAFA Program Changes Announced

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The federal government’s flagship HAFA short sale program continues to evolve in hopes of more effectively addressing the needs of distressed homeowners for whom continued ownership is not longer a realistic option.  The most recent Supplemental Directive 12-02 was released on March 9, 2012; loan servicers are instructed to implement program changes effective immediately.  They include:

  • There are no longer any occupancy requirements for HAFA eligibility.
    Previously, HAFA required that the property be occupied as the borrower’s primary residence at some point within the prior 12 months.
  • The amount a servicer may authorize the settlement agent to pay from gross proceeds to subordinate mortgage holder(s) in exchange for a lien release and full release of borrower liability is increased from $6,000 to $8,500.
  • Borrower relocation incentives will be limited to HAFA short sales or Deed-in-Lieu transactions where the property is occupied by a borrower or a tenant at the time of the Short Sale Agreement or DIL Agreement and who will be required to vacate the property as a condition of the sale or DIL.
  • Borrowers may now elect to remain current on the loan during the term of the Short Sale Agreement or DIL Agreement.
  • Credit bureau reporting of HAFA transactions are amended as follows:
    • If the real estate is sold for less than the full balance owed and the deficiency balance is forgiven, report the following Base Segment fields as specified:  Account Status Code = 13 (Paid or closed account/zero balance) or 65 (Account paid in full/a foreclosure was started), as applicable.
  • The deadline for HAFA has been extended. A borrower now has until December 31, 2013 to submit a Short Sale Agreement or a written request for a consideration for a Short Sale Agreement to be eligible for HAFA.

The stated intention of the program updates is to expand the availability of HAFA’s benefits to more struggling homeowners.  Certainly, the increase in the amount of gross proceeds available to settle junior liens should help.  This has been an area of particular concern, most especially in California where the implementation in 2011 of SB 457 barred
lien holders from reserving collection rights following short sales or, alternatively, from conditioning short sale approval from additional seller contributions.  Of course, as with all previous program changes, the proof will be in the pudding.  Stay tuned….

Playing the Simon card in short sale negotiations

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As a real estate professional negotiating short sales on behalf of underwater property owners, your chances of success are directly tied to the laws that apply to your client’s situation.  In other words, if a lender won’t approve your client’s short sale, what leverage do you have to “push back” and change that decision?

We start by analyzing the client’s foreclosure rights.  That is, what will happen if the short sale doesn’t get approved and the client instead lets the lender foreclose? California has “anti-deficiency” laws that lay out exactly what happens when a lender forecloses.  In most cases, the answer depends on the type of loan (or loans) involved.

A loan that is used to buy a borrower’s primary residence is considered a “non-recourse” loan.  If a lender forecloses on such a non-recourse loan, all it gets is the property.  The law bars the lender from collecting the balance still owing, commonly called the “deficiency.”  (There are some rare exceptions to this rule, typically involving income or commercial properties; those are not addressed here.)

If the borrower took out a second loan as part of the original purchase money financing, that loan is also considered “non-recourse.”  If the first mortgage (known as the “senior lien holder”) forecloses its loan, the second lender (the “junior”) is barred from collecting its deficiency.

In contrast, if the second mortgage was not purchase money but instead was added later (often as a home equity loan or “HELOC”), the loan is considered a “recourse” loan.  In that situation a foreclosure by the senior lien holder usually does not bar the junior lender from collecting its deficiency.  However, there is a very important exception to this law.   That exception is known as the Simon rule (named for a 1992 case called Simon vs. Bank of America).

The Simon rule comes into play where senior and junior liens were issued by the same lender; e.g., Bank of America first and Bank of America second.  In that case, the law bars the junior from collecting its deficiency if the senior forecloses.  The rationale is that the senior has the ability to protect its own junior loan; and where the senior decides not to do so, Simon says that it gives up its right to collect the deficiency on the junior.

If your client has a Simon loan situation, you now have much stronger leverage in negotiating a short sale.  If the lender denies the short sale, you simply advise that your client will let the property go to foreclosure.  In that case, the lender will get zero on its second loan.  And in most situations, lenders would rather get something for their junior lien than nothing.

With the recent changes in California short sale laws – in particular the new SB 458 – many realtors I’ve talked to are afraid that second loans won’t approve short sales.  For that reason, it’s more important than ever to know what exactly cards you can play on your client’s behalf when seeking that approval.  In some cases, the Simon card may just be your “ace in the hole.”

If you suspect you may have a potential Simon situation, first locate copies of the deeds of trust for both the senior and junior liens.  Then give me a call and I’ll help your clients and you analyze those documents to determine if in fact Simon applies.

Finally, I’d like to thank Kim McAtee of Coldwell Banker’s Orinda, California office for suggesting the blog topic.  I always welcome readers’ suggestions on topics they’d like to see.  Thanks, Kim!

SB 458 Fills Hole in Homeowners’ Short Sale Protection

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On July 11, 2011, Governor Jerry Brown signed Senate Bill 458.  Effective immediately, the new law provides critical protection to homeowners pursuing short sales of their underwater properties.

A little background: On January 1, 2011, California’s anti-deficiency laws (contained in Section 580 of the Code of Civil Procedure) were amended to include limited protection to borrowers following a short sale.  Prior to that time, the only anti-deficiency protections available to borrowers occurred following a foreclosure of the loan by the senior lien holder.  By adding subsection “e” to Section 580, Senate Bill 931 enacted a bar against senior lien holders pursuing collection of a loan deficiency following that lender’s consent to a short sale.  Unfortunately, no similar protection was enacted for borrowers with junior liens on their properties.

The problem developed that these junior lien holders were aggressively pursuing collection of loan balances despite agreeing to short sales negotiated by the borrower and the senior lien holder.  The end result was that many borrowers were opting for foreclosure in an attempt to obtain protection under the foreclosure anti-deficiency statutes.  This trend compounded the foreclosure crisis and further drove down property values.  For that reason, and on an expedited basis, the California Association of Realtors sponsored SB 458 specifically to bar collection by junior lien holders who consented to short sales.  That is the legislation that Governor Brown signed on July 11th.

SB 458 is unusual in that it contains an “urgency provision.”  In most situations, there is a lag between the time a governor signs a bill and when it becomes effective.  But SB 458 (which revises the new Code of Civil Procedure Section 580e) by its terms is effective immediately, a clear recognition by the legislature and the governor of the serious nature of the problem created by the junior lien holders’ hard-nosed collection actions.  SB 458 will apply to any short sale that closes escrow on or after July 11, 2011.  (In other words, we look to the date escrow closes, rather than the date of the lender’s approval.)

The law also specifically makes “void and against public policy” any attempt by a junior lien holder to force a borrower to waive the protections of the new law as a condition of a short sale approval.  In other words, even though a borrower may sign a waiver in a short sale approval letter, if escrow closes after July 11, 2011 the lender may not enforce the waiver.

In addition, effective immediately a lender cannot require a borrower to pay any additional compensation in exchange for a short sale approval; however, the new law does not prohibit a borrower from voluntarily offering a monetary contribution to a lender in hopes of obtaining a short sale.  A lender is also permitted under the new law to negotiate for a contribution from someone other than the borrower, such as other lenders, agents, relatives, and the like.

A significant question exists whether junior lien holders will now simply refuse to approve short sales and instead force borrowers into foreclosure, further exacerbating the housing crisis.  A similar concern was raised following the enactment of SB 931; however, that concern has proved largely unfounded.  In short, we will have to wait and see.

If you or a client has questions regarding the applicability of the new legislation to a particular transaction, please contact me and I will be happy to consult with you and/or the client regarding this issue.