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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.

California Short Sale Tax Exemption Hearing Scheduled

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California Senate Bill 30, which will reinstate the state tax exemption applicable to cancellation of qualified mortgage debt, is scheduled for a hearing before the Committee on Appropriations on April 8, 2013.

The bill was previously amended by the Committee on Government & Finance, following which it was approved by a 6-0 vote, subject to approval by the Appropriations Committee.

If the bills successfully emerges from the Appropriations Committee, it will be scheduled for a vote by the full legislature and, if passed, sent to Governor Brown for signature.

As amended, the bill will provide for reinstatement of the state tax exemption retroactive to January 1, 2013 and through December 31, 2013, mirroring the expiration of the federal 982 homeowners’ exemption.   Stay tuned….

Important Update on Status of California Short Sale Tax Issue

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I wrote last week that the federal tax exemption for mortgage debt forgiveness had been extended for one year as part of the “fiscal cliff” settlement between Congress and the White House.

  • California’s Homeowners Exemption has Expired

At that time, I also wrote that the California tax exemption expired on December 31, 2012, without having been extended by the state legislature.  Consequently, mortgage debt forgiveness is currently subject to California state income tax.

  • Senate Bill Introduced to Reinstate the California Exemption

To remedy this inconsistency between federal and state tax law, the California Association of Realtors is sponsoring Senate Bill 30 (Calderon, D-Montebello).  SB 30 will conform state law to the federal law passed last week.  Upon passage of SB 30, the measure as currently drafted will be effective retroactive to Jan. 1, 2013.

  • Contact Your Local State Representative

If you believe the state tax exemption should be reinstated, contact your local state senator and ask that he/she support SB 30.

I will report further as the bill moves its way through the legislative process.

 

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.

 

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.

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.

URGENT: FHFA Announces New Fannie/Freddie Short Sale Guidelines

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The Federal Housing Financial Administration (FHFA) has just announced that it will align guidelines for Fannie Mae and Freddie Mac short sales and allow lenders and servicers to quickly and more easily qualify borrowers for a short sale.  Real estate professionals and associations have long advocated for a streamlined, standardized short sale process, and some of the changes below address some of the main concerns involving these transactions.

Effective November 1, 2012, the primary changes are as follows:

  • Eliminates current Fannie Mae and Freddie Mac short sale programs and creates a single standard short sale process for both entities (Fannie and Freddie HAFA programs will expire at the end of the year).
  • Enables servicers to quickly and easily qualify certain borrowers for short sales who are current on their mortgages without waiting for an approval from Fannie Mae or Freddie Mac Offers special treatment for military personnel with Permanent Change of Station (PCS) orders.
  • Standardizes and clarifies foreclosure suspensions on a property with an approved short sale.
  • May pay borrowers up to $3,000 in relocation assistance.
  • Fannie Mae and Freddie Mac will offer up to $6,000 to subordinate lien holders to expedite a short sale.

FHFA also clarified that a borrower experiencing a hardship must wait at least two years following a short sale before becoming eligible for a new Fannie Mae or Freddie Mac loan.

It is hoped that these new guidelines will improve short sales eligibility for those troubled homeowners trying to avoid a foreclosure so they can move on with their lives.  Of course, only time will tell….

See Fannie Mae’s press release regarding the new short sale guidelines:  http://www.fanniemae.com/portal/about-us/media/corporate-news/2012/5814.html

For a copy of Freddie Mac’s Servicer Bulletin go to: http://www.freddiemac.com/sell/guide/bulletins/pdf/bll1216.pdf

Time ticking down on important short sale tax protection.

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For many homeowners considering a short sale of their property, among the most important factors is whether and to what extent they may face a tax liability as a result of the transaction.  The concern is well founded.

As a general rule, the IRS requires that any lender receiving less than the full amount of mortgage debt owed on a property must send the borrower a Form 1099 for that “deficiency” amount.  In other words, if you owe $250,000, and you short sell your property for $190,000, you will receive a Form 1099 for $60,000.

The most important question is whether you have to pay taxes on that $60,000 of “income.”  Prior to the collapse of the housing market, the income was virtually always taxable.  In 2007, Congress passed the Mortgage Debt Relief Act, which generally allows taxpayers to exclude income from the discharge of debt on their principal residence.  For purposes of the Act, the IRS defined “principal residence” as a property in which the taxpaper lives for a total of 24 of the 60 months preceding the discharge of the debt.

It is important to understand that the tax exemption does not apply to all debt on a principal residence.  The Act applies only to forgiven or cancelled debt used to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes. In addition, the debt must be secured by the home. The maximum amount you can treat as qualified principal residence indebtedness is $2 million or $1 million if married filing separately.

Where a homeowner has “cashed out” equity in a principal residence through refinance or a home equity line of credit for unrelated purposes, the tax exemption does not apply.  Similarly, the exemption does not apply to non-principal residences; i.e., rental or income property.

Now here’s the important part: THE ACT EXPIRES ON DECEMBER 31, 2012!  In other words, if you want to benefit from this very important tax exemption by short selling your home you need to start NOW.  Any delay risks having the sale not be approved, and as a result not closing, before the expiration of the act.

There is a chance that the Act may be extended; however, the current lack of bipartisan cooperation in Washington raises the very real chance that nothing will get done before the next Congress is sworn in next year.  And there’s no guarantee the new Congress will pass the legislation necessary to revive the Act.  Under the circumstances, my advice is better to be safe than sorry.

If you have questions about whether you qualify for the exemption, or have other issues relating to your mortgage, short sales or foreclosures, please contact my office and let’s talk.