Easy Explanation of Foreclosures and Short Sales

I found this article to be of particular interest in a very astute presentation of what foreclosures and Short Sales are all about, I hope you enjoy it.   Please contact me at TimMouton@kw.com or www.TimMouton.com or for a financial and insurance prospective to your real estate transaction tmouton@shoptermquotes.com or www.ShopTermQuotes.com

 

FORECLOSURE/SHORT SALE BROCHURE

This Article is designed to be of general interest. The specific techniques and information discussed may not apply to you. Before acting on any matter contained herein, you should consult with your personal legal adviser.

There are two types of foreclosure in California: Trustee's Sale, and Judicial Foreclosure.

Formerly, JUDICIAL FORECLOSURE was rare but now is increasing in use as property values have dropped. Judicial foreclosure has many disadvantages to the lender. It is not an expedited process (as is the Trustee's Sale), but involves court proceedings, orders, appraisals, and an auction. It takes much longer and costs much more than a Trustee's Sale.

The real difficulty with Judicial Foreclosure is that it allows the Borrower a 1 year "right of redemption" in which he is allowed to buy the property back from the successful bidder. This makes purchases of such property more uncertain and tends to lower the bidding.

The advantage to the lender of Judicial Foreclosure is that a deficiency judgement against the Borrower is allowed. [See exception below for personal residence.] The auction proceeds are used to reduce the debt (including penalties, attorneys' fees, and costs); judgement is entered against the Borrower for the balance.

Whether the deficiency judgment is collectable is another problem for the lender.

A TRUSTEE'S SALE is the easy method of foreclosure. It's fast and inexpensive. However, NO DEFICIENCY JUDGEMENT IS ALLOWED.

In a Deed of Trust the borrower (Trustor) gives the Trustee (typically a title company) the right to sell the property if the Buyer defaults.

The first step is a Notice of Default. It states the amount in default. 90 days is given to cure the default by catching up on all late payments, penalties, and costs.

After the 90 days expires, the lender files a 21 day Notice of Trustee's Sale, at which time an auction is held, usually at Court, with limited publicity resulting in a greatly depressed price. After it is over, the former owner must be evicted if he refuses to leave.

The Borrower can still catch up on all late payments until 5 business days prior to the sale. Within the last 5 days, the only way to stop a sale is by payment in full of the entire balance.

Most lenders prefer NOT to foreclose. Banks are in the money business, not the real estate business. They try to avoid foreclosure, because it is bad for their books if their ratios of REO (real estate owned) and bad debts climb.

EXCEPTION Personal Residence = No Liability

By State law there is never personal liability for a purchase mortgage for a personal residence. The owner can "walk away" from the property with immunity from personal liability regardless of the method of foreclosure.

Deed in Lieu of Foreclosure

This is a short-cut, when the owner accepts the inevitable and gives the property back to the Bank. However, many lenders now refuse to take a Deed in Lieu of Foreclosure. They get "cleaner" title if they foreclose, effectively wiping out all other claims to the property.

Bankruptcy

Many borrowers stall until the last minute and then file bankruptcy to stop the sale. If there is no equity in the property the lender eventually will make a "Motion for Relief from the Automatic Stay" to allow the foreclosure to proceed. This takes time and costs the lender more money.

Foreclosure after Sale

"I sold the property. The loan is still in my name. The buyer was supposed to make all the payments. Now the Bank is foreclosing and sending me notices."

As discussed above, if the lender uses the Trustee's Sale, it waives any right to seek a deficiency judgment against anyone.

Therefore, a seller who is still on the mortgage for his former property has little (if any) real risk of liability for a deficiency.

The next concern is, "But will it affect my credit?"

If the former owner can prove that the loan was current when he sold the property, although it may show on a credit report, a letter to the credit agency explaining that the foreclosure was after a sale, usually works.

"I'M BEING FORECLOSED. What can I do?" See a lawyer! Talk to the lender. Try to get an extension, lower interest, or reduced payment.

"SHORT SALE"

Most lenders are in the money business and would rather not own real estate. If the value of the property has decreased, some lenders cooperate and allow a sale of the property, instead of forcing a foreclosure.

If the debt is greater than the property's value, in order to sell it and turn the lender's interest into cash, the lender must agree to accept less than full payment as satisfaction of the debt.

Many lenders realize that some money soon is better than less money (since foreclosure auctions usually bring low prices) later, especially if the debt continues to increase during the pendency of the foreclosure.

TAX CONSEQUENCES

Most people are shocked that they can lose their property and still owe taxes on the profit. We often hear people say that they prefer to be foreclosed since they will not owe any tax, but if they sell (and have no net sales proceeds) they will owe substantial tax. WRONG!

The tax results of a foreclosure, deed in lieu of foreclosure, or short sale depend on the nature of the loan: whether it is recourse or non-recourse. Recourse means that the borrower has personal liability for the loan, in addition to the risk of losing his real property.

Tax Consequences: NON-RECOURSE LOANS

Non-recourse loans include typical California purchase loans used to buy an owner occupied residence of up to 4 units.

 

State Law protects borrowers from personal liability on a purchase mortgage for a home which they occupy at purchase. (If the borrower later converts the home to rental, he is still protected.) The State has put the risk on the lender; the most a lender can do is take back the house. This law applies to properties of up to 4 units, and applies only to loans used to purchase the property.

Purchase loans include bank loans and seller carrybacks.

Some cases allow the same protections for refinances IF there is no cash paid out to the borrower, or if any cash paid out is used for property repairs or improvements.

If the loan falls within this statutory protection, it is a non-recourse loan. Other loans may be non-recourse by their terms.

[Special rules may apply to VA and FHA loans.]

The tax consequences of foreclosure, deed in lieu of foreclosure, or short sale on a non-recourse loan are simple: the property is taxed as if it were sold for the total outstanding amount of the loan (or sales price, if higher). Taxability of the gain and deductibility of the loss depend on the nature of the property.

Tax Analysis Examples:

1) Bob owes $100,000 on a property he bought for $130,000, now worth $80,000. If Bob is foreclosed, gives the property to the lender, or the lender accepts a short sale payoff, Bob is taxed as if he had sold the property for $100,000.

Bob's loss of $30,000 is not deductible if it is his residence, but is deductible if the property is a rental.

TAX TIP: If you expect a loss on your own home, move out, rent the property, and then the loss may be deductible since the property is a rental!

2) Sam owes $100,000 on a property he bought for $95,000, now worth $80,000. If he is foreclosed, gives the property to the lender, or the lender accepts a short sale payoff, Sam is taxed as if he had sold the property for $100,000.

Sam's profit of $5,000 is subject to the rules for sale of residences [2 year rollover & Over-55 Rule apply], or rental property, depending on Sam's use of the property.

3) Ted owes $100,000 on a property he bought for $95,000. At the foreclosure auction, it sells for $110,000. Ted is taxed as if he had sold the property for $110,000.

[These examples are over-simplifications: the tax basis (for determining gain or loss) is not the cost of property. Rather, initial cost is reduced by depreciation and profit rolled over from prior sales, increased by capital expenditures, and affected by other tax rules. Also, in a Deed in Lieu of Foreclosure, the deemed sales price includes an additional factor: past due interest, but an offsetting interest deduction is allowed.]

Tax Consequences: RECOURSE LOANS

A recourse loan is a loan where the borrower is personally liable if the property is sold for less than the amount owed to the lender.

There are two issues with a recourse loan: personal liability and taxation.

Liability: Recourse Loan

To obtain a personal judgment against the borrower, the lender must proceed with a Judicial Foreclosure. Even if the loan was recourse, if the lender proceeds with a Trustee's Sale, the borrower is relieved from personal liability for any remaining deficiency (which the lender cannot collect under a Trustee's Sale).

Taxable Profit: Recourse Loan

There are two elements of profit: `true profit,' and relief from debt income. `True profit' is computed as if the property were sold for its value; relief from debt income is taxable if the debt exceeds the property's value.

A foreclosure, Deed in Lieu, or a short sale (involving recourse debt) are taxed identically.

If the debt is $200,000 and the property's value is $180,000, the owner's `true profit' is taxed as if he had sold the property for $180,000; relief from debt income is taxable on the $20,000 debt in excess of the property's value.

If the owner's "cost basis" is less than the value, he has a taxable `true profit.'

["Cost basis" is determined by examining the property's initial cost, plus capital improvements, less any deferred profit from prior tax deferred sales (from the 2 year rollover of a primary residence or §1031 for investment property). If the property cost $250,000 and profit of $100,000 was rolled over from prior sales into this home, its cost basis is $150,000.]

`True profit' is taxed as if from a regular sale of the property and may qualify for a tax deferred sale of a primary residence (§1034) (if he plans on buying a new home within 2 years), and for the Over-55 Rule.

The other kind of taxable income is `relief from debt income,' based on the difference between what is owed and the value of the property, $20,000 ($200,000 debt, less $180,000 value).

The 2 year rollover (§1034) and the Over-55 Rules do NOT apply to relief from debt profit.

Relief from debt income is taxable only to the extent that the debt relief results in solvency. If the owner has a negative net wealth before and after the sale, nothing is taxable. Alternatively, if he has negative net worth before, and $3,000 net worth after, up to $3,000 is taxable.

If the owner is in bankruptcy, no relief from debt income is taxable.

These rules are complicated and point out that in any circumstance in which unexpected tax results are possible, a thorough examination by an experienced tax professional must be sought BEFORE IT IS TOO LATE.

BOSTON HARBOR SCAM

"PAY US A FEE. SIGN OVER TO US YOUR FORECLOSURE PROPERTY. YOU AVOID TAXES AND PROTECT YOUR CREDIT!"

WRONG! The old rule, "If it sounds too good to be true, it probably is" really works. Companies such as Boston Harbor make many promises but the truth is far short.

As outlined above, the tax results of a foreclosure, deed in lieu of foreclosure, or short sale depend on the nature of the loan: whether it is recourse or non-recourse.

NON-RECOURSE LOANS

Bob bought his first house for $150,000, with a $120,000 mortgage from Bank. The value drops to $100,000. What should Bob do? He can:

1. Give Bank a Deed in Lieu of Foreclosure;
2. Let Bank foreclose;
3. Make a short sale, if Bank approves; or
4. Pay a fee to Boston Harbor, deed them the property, and "forget all his problems."

Bob has exactly the same results under each one of these plans, except for the last option where he pays unnecessary fees.

Regardless of what he does, Bob is taxed as if he sold the property for the total debt: $120,000.

Advertisements by Boston Harbor and others talk about relief from debt income, and state that Bob has a big problem which they can solve. WRONG! Relief from debt income does NOT apply to Bob's loan: it is a non-recourse loan.

No matter what Bob does, the property is taxed as if it were sold for the total outstanding amount of the loan (or sales price, if higher). If Bob's tax basis is above that amount, he has a loss (non-deductible if it is his residence); if his basis is less than the balance owed, he has a profit [Bob can use the 2 year rollover rule & the Over-55 Rule].

In a non-recourse loan, there is no relief from debt income.

There is absolutely no benefit from using Boston Harbor if you have a non-recourse loan.

RECOURSE LOANS

If the debt is $200,000 and the property's value is $180,000:

1 - `True profit' is taxed as if he had sold the property for $180,000. The result depends on the owner's cost basis and use of the property.

2 - `Relief from debt income' is taxable on the $20,000 debt in excess of the property's value.

The 2 year rollover (§1034) and the Over-55 Rules do NOT apply to relief from debt profit.

As described above, relief from debt income is taxable only to the extent that it results in solvency. However, if the owner is in bankruptcy, no relief from debt income is taxable.

These rules apply even if the property is deeded to Boston Harbor, or to your brother-in-law.

The IRS and State Attorney General are investigating Boston Harbor and other similar companies.

In February, 1995, the State of California filed a lawsuit against Boston Harbor seeking an injunction and monetary damages

 This information was provided by: Copyright 1996, Marc S. Weissman
Weiss & Weissman, San Francisco, California.