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 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.

Still No News on SB 30 (StateTax Exemption for Forgiven Mortgage Debt)

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As scheduled, the state legislature’s Appropriations Committee held a hearing earlier this month to determine the fate of Senate Bill 30.  As a reminder, this is the bill that, if passed, would restore the state tax exemption for the “shadow income” homeowners are imputed to have received if their home is foreclosed or sold in a short sale.  That exemption expired on December 31, 2012.

Unfortunately, the committee chose to “table” consideration of the bill to a later date.  Specifically, the bill was placed in the AC’s  “Suspense File”, to which the committee sends any bill with an annual cost of more than $150,000.  Suspense File bills are then considered at one hearing after the state budget has been prepared and the committee has a better sense of available revenue. No testimony is presented – either by the bill’s author or any witness – at the Suspense File hearing.

At present, we have no definitive date on which the Suspense Bill hearing will occur.  And the current high volume wrangling between the governor and the legislature over education funding makes it unlikely a final vote on SB 30 will occur pending resolution of these other political “hot potato” budget issues.  Stay tuned.

URGENT: Homeowners Tax Exemption Extended Through 2013

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The 2007 Mortgage Debt Relief Act, which was scheduled to expire at midnight on December 31, 2012, has been extended for one year as a result of the “fiscal cliff” deal struck between Congress and the president.

The Senate included the extension as a part of the bill that passed at 2:00 a.m. on Tuesday morning.  After House Republicans failed to pass a separate bill modifying the Senate plan, that plan was presented for a full house vote late last night and passed 257-167.  President Obama has stated he will sign the bill.

EXTENDS TAX FORGIVENESS FOR MANY HOMEOWNERS WHO COMPLETE A SHORT SALE, FORECLOSURE, “DEED IN LIEU”  OR LOAN MODIFICATION IN 2013.

This is very important news for homeowners whose short sales and “deeds in lieu of foreclosure” had not been concluded by December 31st, and who were facing a substantial income tax bill if the exemption had expired and not been renewed.  It also will benefit many homeowners whose properties are foreclosed in 2013, as well as individuals who obtain a “principle reduction” loan modification on their home mortgages.

EXEMPTION DOES NOT COVER ALL FORGIVEN MORTGAGE DEBT

As I have previously explained, the tax exemption does not apply to all forgiven mortgage debt.  Specifically, the debt must have been on a primary home, and the debt must have been used to either buy the property, to pay off purchase debt, or to repair/renovate the home.  It does not apply to debt on second homes or income property, or on “cash out” refi debt.

STATUS OF CALIFORNIA’S SEPARATE TAX EXEMPTION NOT YET CLEAR

Keep in mind that the separate California tax exemption for mortgage debt relief also was scheduled to expire on December 31, 2012.  Whether that state exemption will be extended as a result of the federal extension is not yet known.  I will report further once that information becomes available.

I recommend you immediately contact your local representative if you feel the California tax exemption should also be extended.

CONSULT WITH A QUALIFIED ATTORNEY OR TAX ADVISER NOW TO DETERMINE IF YOU QUALIFY

For “underwater” homeowners that have been “sitting on the fence”, now is a good time to speak with a qualified real estate attorney or tax adviser to determine whether and to what extent you qualify for the extended tax exemption.  Keep in mind that it can take many months for a short sale, loan modification, “deed in lieu” or foreclosure to be completed.  For that reason, it’s important to get the process started as soon as possible.  That way you can implement your best strategy without having to worry about losing the tax exemption at the end of 2013.

 

“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.

Short Sale Tax Exemption Update

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I recently attended a networking event of local Bay Area realtors, and was shocked to hear a young realtor say she had heard that the short sale homeowners tax exemption, scheduled to expire on December 31, 2012, had been extended.  I quickly informed her that her information was incorrect, and that the exemption remains on track to expire at the end of the year.  My purpose in this blog is to provide a status update regarding the homeowners exemption, and to clarify the availability of another potential tax exemption for homeowners unable to complete their short sale in time.

As a reminder, homeowners whose mortgage debt is forgiven, reduced or cancelled in a short sale, foreclosure or loan modification will receive a 1099 from their lender in the amount of the unpaid debt.  And unless they qualify for a tax exemption, they will have to pay income tax on the 1099 amount.  Since 2007, many homeowners have been able to avoid the tax by applying for the IRS Form 982 homeowners exemption.  (The exemption does not apply to all home mortgage debt; there are limitations that can be explained by a knowledegable tax professional.)

First, it is correct that President Obama has proposed that Congress extend the homeowners tax exemption, also known as the Mortgage Forgiveness Debt Relief Act, through 2013.  But it is only a proposal.  The Senate Finance Committee has also approved a bill to extend the Act; however, that’s as far as it’s gotten.  And the highly partisan congressional and presidential battles makes it virtually certain that nothing will happen until after the November 6th national election.

The hope is that the “lame duck” congress will then extend the exemption.  Knowledgeable prognosticators currently place the odds at 60/40 in favor of the extension; however, that is only speculation.  There is a significant risk that the looming “financial cliff” and public pressure to reduce the deficit may torpedo the exemption.  Congressional estimates are that a one-year extension of the Act will reduce government revenues by as much as $1.3 billion.

Homeowners facing potential tax liability from mortgage debt cancellation — resulting either from a foreclosure, short sale or loan modification — are urged to determine if they qualify for the “insolvency” exemption.  Unlike the homeowners exemption, the insolvency exemption does not expire this year.  And it is available for more types of mortgage debt that the homeowners exemption.

Briefly, if the fair market value  of all your assets, including your retirement accounts, is less than your total debt, you are “insolvent” for tax purposes.  Depending on the extent of your insolvency,  you may be able to reduce your 1099 mortgage debt tax liability.  For example, if you have $100,000 in 1099 mortgage debt income, and your debts exceed your assets by $50,000, your taxable income is reduced by $50,000.  (Again, these calculations should be done by a qualified tax professional.)

Please contact me if you need help determining your individual situation.  It is critical you make no decision unless and until you know the consequences.  An incorrect choice may potentially place you in even worse condition, something few homeowners can afford.