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Foreclosure Tax Law 2013: Residential California Home Owner Liability

Current foreclosure tax law requires home owners to pay taxes for capital gains or losses & potentially debt-relief income if the loan is recourse

Consumer Protection Laws & Borrower Tax Liabilities

In last week’s post – “California Foreclosure Real Estate Law: Is There a Right Time to Walk Away?” – we examined the circumstances in which a defaulting borrower may be sued by a lender for a deficiency judgment in a residential foreclosure. Another pressing financial issue facing borrowers that walk away from  under water real property concerns the tax impact under the IRS and California’s foreclosure tax law. Foreclosed home owners have the potential of incurring two types of taxes – “debt relief income” and/or “capital gain or loss” – under 2013 foreclosure tax law. It’s important to remember that a borrower’s legal liability and tax liability are unrelated. So, a borrower may escape legal liability, yet still be on the hook and owe taxes to the IRS and the California State Franchise Tax Board. First, we’ll examine the meanings of “debt relief” and “capital gains or losses” in the context of 2013 foreclosure tax law. Next, we’ll analyze some examples to help clarify comprehension of these confusing foreclosure tax law concepts.

What is “Debt Relief Income” under Federal & State Foreclosure Tax Law?

When you borrower money from a lender and the lender cancels or forgives the debt owed in a foreclosure, the forgiven (or “relieved”) amount is considered ordinary income and is taxed as such under foreclosure tax law. It works like this. Loan proceeds of borrowed money is initially excluded from borrower’s income because there is an existing obligation to repay the lender. When the lender subsequently cancels (or “relieves”) borrower of repaying the obligation through foreclosure, the IRS treats the amount borrower is “relieved” from paying lender as reportable income. If the cancelled debt (commonly called “debt relief income“) is more than $600, the lender is required to send the borrower a 1099C – Cancellation of Debt form showing the amount of debt cancelled and the fair market value (FMV) of the foreclosed property.

Federal “Primary Residence” Debt-Relief Exception

Don’t panic just yet! The Feds created an exception for home owners under the Mortgage Forgiveness Debt Relief Act of 2007. The Act allows borrowers to exclude up to $2 million ($1 million if married filing separately) of forgiven debt as a result of a foreclosure on borrower’s primary residence. Originally set to expire on December 31, 2012, the Act was extended until December 31, 2013, at which point lawmakers will reconsider extending the primary residence foreclosure tax law exception. This raises special concerns for home owners with looming foreclosures because the primary residence exception under current foreclosure tax law may be unavailable to home owners in the future.

California Conforms to Federal “Primary Residence” Debt Relief Exception with Limitations

The Golden State followed suit by also extending “primary residence” debt relief protections for foreclosed home owners. The protection has more limitations than its federal counterpart in that it only covers debts discharged before January 1, 2013, with the maximum exclusion amount being $500,000 of forgiven debt ($250,000 if married filing individually). Senate Bill 30, which would extend the protection of forgiven debts discharged on or after January 1, 2013 and before January 1, 2014, is under urgent review by California legislature. All signs point to SB 30 passing, but you never know. Stay tuned for how the Feds and the State of California are going to handle foreclosure tax law matters after January 1, 2014.

What are “Capital Gains and Losses” in Context of 2013 Foreclosure Tax Law?

In a typical sale, real property goes through escrow and the seller receives statements showing the home’s sale price. Foreclosures, on the other hand, do not go through escrow. The lender simply takes possession of the property after the foreclosure is completed. The formula to calculate capital gain (profit earned from sale) or loss (money lost from sale) is the difference between the owner’s “basis” and the “selling price” of the home. Sales under foreclosure tax law differ from standard sales as the “selling price” of a foreclosed home isn’t always clear and differs depending on the type of loan borrower holds. The selling price for foreclosures where borrower holds a non-recourse loan is the loan balance immediately before foreclosure. For recourse loans, the selling price is the lesser of the property’s fair market value (FMV) or outstanding loan balance prior to foreclosure. Lenders report the property’s FMV, existing loan balance and foreclosure date to borrowers using 1099-A – Acquisition or Abandonment of Secured Property. Borrowers use the form to determine if they need to report capital gain or loss under foreclosure tax law.

Foreclosure Tax Law Consequences Depend on Loan Type

Current foreclosure tax law requires borrowers to file taxes for capital gains or losses & income earned as debt-relief for borrowers holding recourse loansThe foreclosure tax law consequences depends on whether defaulting borrower’s loan is a non-recourse debt (a loan used to acquire the property), or recourse debt (loan taken out after purchase of the property, some refinances, “sold out” junior mortgages, etc). The IRS treats a foreclosure as a sale regardless of whether a loan is non-recourse or recourse. The seller is the owner, the buyer is the foreclosing lender and the selling price is the amount of loan discharged (non-recourse) or the lesser of FMV or debt discharged (recourse).

Non-Recourse Loan Foreclosure Tax Law Rules

A non-recourse loan is one in which the borrower is not personally liable for repayment. Once the lender repossess the property used to secure the loan, the loan is satisfied and the lender cannot pursue borrower personally for further repayment regardless of the amount that borrower is “deficient” in paying lender.

Borrowers holding non-recourse loans can incur a capital gain or loss only under foreclosure tax law, which is calculated as the difference between debt discharged (“selling price” for non-recourse loan) and owner’s basis. A capital gain results if the debt discharged exceeds owner’s basis. A capital loss results if the debt discharged is less than owner’s basis.

Borrowers holding non-recourse loans don’t incur income from debt relief under current foreclosure tax law.

Non-Recourse Examples

Example 1 Barry Borrower acquires $500,000 fully financed home (i.e. “purchase money” non-recourse loan = $500,000). The home depreciates $100,000 by the time lender forecloses the unimproved property. A capital gain results if the amount of the loan discharged exceeds the home owner’s tax basis (or purchase price  + improvements – depreciation) in the property.

   $500,000 (Nonrecourse Loan/Debt Discharged)

-($400,000) (Basis)

  $100,000 Gain

Borrower will incur a $100,000 capital gain. Borrower can utilize homeowners exclusion ($250,000 for individuals) to exclude the capital gains tax. Borrower will not have ordinary income for the forgiven debt because the loan is non-recourse. And, as we learned last week, the lender cannot sue borrower to collect $100,000 deficiency (difference between loan amount and fair market value) because the debt is non-recourse.

Example 2: Borrower buys home for $200,000 by taking out $180,000 interest-only purchase money loan and putting $20,000 of his own money down. Borrower never improves the home and rents it out for his entire ownership. After several years of ownership, after depreciation write-off, Borrower depreciates home so his new basis is $175,000. The FMV of the home at time of the foreclosure is $170,000 with loan balance still at $180,000.

   $180,000  {Selling Price/Debt Discharged}

-($175,000) (Basis)

       $5,000 Gain

Borrower will incur $5,000 capital gain. Unlike in example above, Borrower cannot use the home owners exclusion to exclude capital gains tax as the property is not his primary residence – he rents it out. Borrower doesn’t incur ordinary income from debt relief because the loan’s non-recourse. Lender’s only recourse is to take property back as there is no right to sue Borrower for a deficiency judgment – again, because the loan is non-recourse. Borrower may be able to offset the capital loss with a capital gain on another asset.

Recourse Loan Foreclosure Tax Law Rules

A recourse loan is a loan where the borrower is personally liable for the debt. In addition to taking your property back, recourse lenders can file a lawsuit, garnish wages, and/or levy bank accounts to collect the rest of the money borrower owes.

Borrowers holding a recourse loan may incur both a capital gain or loss and “debt relief” income. A capital gain results to the extent that the lesser of the FMV or loans encumbering the property exceeds the owner’s tax basis. Borrowers holding recourse loans incur debt relief income on the amount that they were “deficient” in paying the lender (the difference between the debt discharged and FMV of the property at the time of foreclosure).

Special “Refinance” Rules

It’s important to note that loans that were refinanced before January 1, 2013, transform into recourse loans on any type of refinance (cash out or otherwise). Loans that were refinanced (not including “cash out” refinances) after January 1, 2013, maintain their non-recourse status, so long as the refinance was used to pay-off the original loan. What does this mean? A foreclosed home owner that refinances with no cash-out after January 1, 2013, will only incur a capital gain or loss and no debt-relief income. A cash-out refinance regardless of when performed (before or after January 1, 2013), the proceeds of which are not used to “build or substantially improve the home,” are treated as recourse debts. The consequence? The foreclosed home owner has the potential for a capital gain/loss and debt-relief income payable to the Feds in a cash-out refinance. As mentioned above, State law conformed to Federal Law for refinances made up to 2012. But, California has yet to approve SB 30, which would protect refinanced home-owners (except cash-out refinances) from incurring debt-relief income in 2013 and beyond. The result? Foreclosed home owners will have to pay debt-relief income on the “deficiency” to the state on any type of refinance made in or after 2013.

Recourse Loan Example

Onyx Owner buys a pristine home on January 1, 2004 for $500,000. Owner financed the home with a $450,000 non-recourse “purchase money” bank loan and $50,000 down payment. The home’s value sky rockets a couple years after Owner’s purchase. Owner has great job and is able to pay-off the loan. Owner refinances the entire loan ($450,000) in 2006 as she needs liquid cash to help her 3 kids go to college, so she does not use the refinanced proceeds to build or substantially improve the home. This refinance transforms the loan into a recourse loan. Owner loses her job and stops making mortgage payments in the first half of 2008 when the principal mortgage amount due was $432,500 and adjusted basis in the property (after accounting for depreciation) was $405,250. Owner’s bank forecloses and takes back the property, at which time the fair market value is $425,00.

Capital Gain or Loss Formula: Lesser of (FMV or Amount of Debt Discharged) – Owner’s Tax Basis

   $425,000 lesser of {($425,000 (FMV) or $432,500 (Debt Discharged)}

($405,250) (Owner’s Tax Basis)

      $19,750 (Gain)

Remember, if this a primary residence, Owner can utilize the homeowner exclusion to exclude any capital gains earned up to $250,000 ($500,000 married couples).

“Debt Relief” Income Formula:  Lesser of {(Debt Discharged  – FMV)}

    $432,500 (Debt Discharged)

-($425,000) (FMV)

       $7,500 (Debt Relief Income)

Owner will have to report the amount of forgiven debt ($7,500) on “Form 982 – Reduction of Tax Attributes Due to Discharge of Indebtedness” (attached to filed tax return) and pay income taxes, unless an exception exists. Since this is Owner’s primary residence, Owner can exclude debt-relief income of up to $2 million for the Feds and up to $500,000 in California. Owner won’t have to pay debt-relief income here since this is her primary residence and the debt relief is less than the allowable exclusion amounts. It’s important to note that Owner can also escape debt-relief tax liability if: (A) she files for Bankruptcy and discharges the debt; or (B) she’s found to be insolvent (liabilities > assets) at the time the debt is discharged.

Foreclosure tax law is in flux. We’re unsure if the Mortgage Debt Relief Act or California’s protection for debt relief incurred on primary residence will be extended into 2014. If you’re thinking about walking away from your under water real property, it’s wise to consult with a real estate attorney that’s familiar with the current foreclosure tax law so you know where you stand when the dust clears.





About Sean Hanley

Practicing law since 2007, Sean specializes in the ever-changing laws related to real estate, business and estate planning. Embracing technology with a focus on personalized service, he understands the challenges of living and thriving in Silicon Valley. Tapping into his education in economics and business administration, Sean also serves on the non-profit Willow Glen Business Association.

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