Understanding Foreclosure Deficiencies and Debt Forgiveness

In today’s current real estate market, many owners are upside down on their real estate homes and/or investments. When the property is sold, whether voluntary or involuntary, this shortfall needs to be addressed one way or another and the effect of same can have substantial financial impact.

Being “upside down” means that the amounts owed on all loans on your property, determined at a specific time and in a specific manner, exceeds the value of your property. This “value” can change depending on whether the calculation is being made as a part of a deed-in-lieu, a short sale, or a foreclosure.

In a deed-in-lieu transaction, the owner transfers the property to the lender in satisfaction of the mortgage encumbering the property. If the lender determines that the value of the property in question is less than the mortgage debt, a deficiency arises. By way of example, if the lender is owed $329,000.00 at the time of the deed-in-lieu transfer date, and the lender has determined that the property’s value is only $270,000.00, a deficiency of $59,000.00 would exist.

In a short sale, the deficiency is determined based on the net proceeds received by the lender at the time of the sale. Using the same values described above, if the property is sold for $270,000.00, the net proceeds given to the lender will be substantially less. Assuming a six percent real estate commission, and traditional closing costs (documentary stamp tax, title insurance and tax credits), the net proceeds to a lender on the sale will likely be less than $250,000.00 resulting in a deficiency of over $79,000.00.

Deficiencies in a foreclosure are judicially determined after the foreclosure sale. If a lender is seeking a deficiency, the lender must apply to the court and provide appraisal information to support the valuation. The property owner has an opportunity to challenge the valuation by submission of evidence to support a higher valuation. At the deficiency hearing, the court determines the property’s value as of the foreclosure sale date and then calculates the amount of the deficiency.

If a deficiency exists, there are several possibilities that a property owner might face depending on what the lender chooses to do with regard to the shortfall. This includes debt forgiveness, collection by the lender or sale of the debt to a third party for collection. In addition, in many cases, an owner will have a first and second mortgage on their property. Generally the second mortgage lender gets little or no money, and may take action separate and apart from the action of the first mortgage lender, even if the loans are titled in the name of the same lender (most loan holders are servicing agents who may own a portion of or none of the actual loan and the actual owners may direct that different action be taken on each loan).

If the lender elects to forgive the indebtedness, the lender will send the property owner a Federal tax Form 1099-C. This is notice to you from the lender that the debt is cancelled and no collection effort will be made on the debt. The amount of the debt forgiven is determined in the same manner as the deficiency. Cancelled debt is generally treated as taxable ordinary income to the recipient of the debt relief unless some exception applies.

For example, if a property is foreclosed and the final judgment amount is $450,000.00, and the property has a value of $400,000.00 at the time of the foreclosure sale, the debt forgiveness will be $50,000.00. This $50,000.00 will be taxable income and treated as if someone paid you the actual money even though you did not receive any payment. If your blended tax rate is 20%, you would owe $10,000.00 in tax on this amount.

There are several exceptions to the taxability of the loan debt forgiveness. However, it is crucial that a Form 982 be filed with a tax return to make sure that the debt cancellation is addressed, regardless of whether the debt relief is taxable. The most common exceptions are as follows:

1. Qualified principal residence indebtedness: This is the exception created by the Mortgage Debt Relief Act of 2007 and applies to most homeowners.

2. Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.

3. Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your total assets.

4. Non-recourse loans: A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property used as collateral. That is, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income.

The Debt Relief Act of 2007 was created to address the growing number of foreclosure on property for which the mortgage debt exceeds the value of the property. Effective for the tax year 2007 and valid through 2012, the Debt Relief Act allows homeowners to be exempt from taxation for debt forgiveness for loans up to two million dollars (one million for married couples filing separately) which secured the taxpayer’s primary residence. The Debt Relief Act has certain restrictions which may affect if any tax due as follows:

1. Only the debt given to acquire, build or substantially improve the residence is exempt. People who cashed out their equity via a refinance will only have a partial exclusion. For example, if the home was originally financed with a $300,000.00 loan, refinanced with a new loan for $400,000.00 in a cash out, and the value at foreclosure is $250,000.00 the taxpayer will have $50,000.00 in exempt income and $100,000.00 in taxable income.

2. The Debt Relief Act only applies to an owner’s primary residence. Second homes, rental property, vacation homes and investment property are excluded and debt relief on these properties will result in taxable income, unless another exception applies.

In order to obtain the exception, a taxpayer must complete new IRS Form 982 to evidence the debt forgiveness and to calculate the exemption amount. According to the IRS, in most cases the application under Form 982 only requires that a few lines be completed to obtain the appropriate relief.

As part of the debt forgiveness process, a careful examination of the amount forgiven and the value of the home listed on the 1099-C should be checked, especially if tax liability exists. If these figures are incorrect, the lender should be notified and an attempt to obtain a revised 1099-C should be made. If the lender refuses to make the corrections, you should consult a tax professional for assistance in challenging the 1099-C amounts with the IRS.

If the Lender does not forgive the indebtedness after foreclosure, short sale or deed-in-lieu, then the deficiency becomes an unsecured obligation of the maker on the note. In a foreclosure action, a deficiency is created by judicial determination. After the foreclosure sale, the lender applies to the court for a deficiency based on the value submitted by the lender. A property owner can challenge this valuation at the deficiency hearing by presenting evidence (appraisal or comparables) to support a higher value. At the hearing the court then determines the amount of the deficiency and awards the lender a judgment based on that amount.

If the deficiency arises from a short sale or deed-in-lieu, the lender must bring an action on the note against the maker, seeking the shortfall. As part of this process, a challenge to the amount due can be made. At the end of the lawsuit, the lender obtains a judgment against the maker under the note and can begin collection proceedings. In next month’s article we will discuss deficiency judgments and collections.