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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 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.

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.

“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.

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!