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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….

 

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.

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.

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.