The Unanticipated Tax Consequences in a Short Sale or ForeclosureSeptember 21, 2007Taxation Committee Real Estate Finance Committee Legislative CommitteeThe following is for study only and has NOT been approved by the Taxation Committee, Real Estate Finance Committee, Legislative or Executive Committees or the Board of Directors.Issue Should homeowners who are already losing their home due to a short sale or foreclosure be relieved of also having topay income tax on the forgiveness of the outstanding debt?Action OptionalOptions 1. Sponsor legislation that would characterize refinanced debt as non-recourse as opposed to recourse debt which would, thus, preclude a taxpayer from having to potentially pay income tax on debt forgiveness income that may occur in the event of a short sale or foreclosure.2. Support legislation described in Option 1.3. Sponsor legislation that would require lenders to provide a disclosure to homeowners that are refinancing, taking out a second mortgage or getting a home equity line of credit informing them of the tax consequences that may potentially occur in the event of a short sale or foreclosure.4. Support legislation described in Option 3.5. Other.6 Do nothing.Status/Summary In a short sale or foreclosure, the homeowner not only loses their home but may also end up being taxed on income they never received. In both instances, the lender ends up getting less than the full amount of the outstanding balance and, consequently, the amount the borrower is no longer responsible for paying to the lender is considered cancellation of debt (COD) income and, thus, income to the borrower and subject to income tax. This scenario cannot happen if the outstanding mortgage debt is from the original mortgage because under state law the borrower can “walk away” from the mortgage with no personal liability. However, if the homeowner refinanced their mortgage, the nature of the debt was changedand the homeowner is personally liable for payment of the debt. Conceivably, since the borrower is already losing their home they should not also have to pay income tax. At a minimum, should consideration be given to requiring a disclosure from lenders to homeowners who are refinancing, taking out a second mortgage or a home equity line of credit as to the potential tax implications that may occur in the event of a short sale or foreclosure?Discussion The recent rash of foreclosures has highlighted a “double whammy” that can occur in a short sale or foreclosure action: the former homeowner not only loses their home but is also taxed on income they never received. State Senator Lou Correa has already announced that he plans to introduce legislation to address this issue at the state level and plans are also afoot for action at the federal level. (Note: See the federal issues summary of the Taxation Committee’s Agenda Summary for more information regarding thefederal level action.)How can this problem arise? Suppose that a homeowner lost their job, became seriously ill or lost their spouse such that they were unable to continue to make their home mortgage payments. Two things can occur at this point. The homeowner can negotiate a “short sale” with their lender in which the lender agrees to let the borrower sell the house for less than the outstanding amount of the mortgage and turn the proceeds from the sale over to the lender aspayment in full. Or, the homeowner fails to make the regular mortgage payments and the lender forecloses on the home which results in the lender selling the home to satisfy all or a portion of the outstanding mortgage loan balance. Note that a“down” housing market has the effect of increasing the difference between the amount for which the home is sold and the amount of the outstanding mortgage loan balance due to the home commanding a lower sale price. Consequently, the lender ends up receiving less than the full amount of the outstanding balance.In both instances, the amount the borrower is no longer responsible for paying to the lender is considered cancellation of debt (COD) income and, thus, income to the borrower subject to income tax. How can this be considered income given that it appears that the borrower never received any money? In fact, when the borrower took out a mortgage to purchase their home, the lender gave the borrower money which used to pay the previous owner of the home. However, because there was an offsetting obligation – the mortgage debt – the borrower/new homeowner wasn’t taxed. If any portion of that offsetting obligation is eliminated – like in a short sale or foreclosure – it is considered income. This income is not considered any different than what is normally considered income. And, in fact, can result in a “third whammy” in that the additional COD income can push the borrower into a higher tax bracket so that not only do they have to pay taxes on the COD income but have to pay taxes on all their income – including the COD income – at a higher tax rate!There are three instances in which income tax will not have to be paid on COD income. Two are bankruptcy and insolvency. So, arguably, an individual that was less responsible than someone who arranged a short sale with their lender or who tried to make their mortgage payments but ultimately failed isin a better position vis-à-vis their income taxes. Needless to say, however, bankruptcy and insolvency have their own financial downsides.The third instance is if the mortgage is “non-recourse” debt. Under state law, there isno personal liability for a purchase money mortgage for a personal residence (which can include an owner occupied residence of up to 4 units) or the financing carried back by the seller. The borrower can simply walk away from the debt and the lender has no recourse for recovering the amount of the outstanding mortgage balance from the borrower. However, if the debt does not meet either of these two exceptions, the mortgage is considered “recourse” debt and any COD income is subject to income tax.More importantly, there are a number of ways in which the characterization of debt secured by a home can change from non-recourse to recourse debt – ways that the borrower may not realize are changing the nature of the debt and, thus, the tax consequences. Chief among these is if the home was refinanced – which countless numbers of homeowners have done over the past few years when interest rates were declining; any amount refinanced is recourse debt and, thus, subject toincome tax. (The same is also true of second mortgages and home equity lines of credit).So, what could be done to help homeowners who through no fault of their own, in addition to not only losing their home, also have to pay income tax on COD income– which increases in a “down” housing market which is also not the fault of the homeowner – as the result of a short sale or foreclosure? The simple answer is to allow the debt to retain the original characterization as non-recourse debt.However, homeowners often refinance for a new debt amount that is greater than the outstanding balance of the original mortgage. They do so for a variety of reasons, ranging from wanting to remodel their home to taking a vacation to Tahiti. Thus, the question arises as to whether the retention of the characterization as non-recourse debt suggested above should apply to (1) all debt refinanced, (2) the remaining portion of the original mortgage and any additional debt used for home improvements, or (3) only the outstanding balance of the original mortgage.Finally, if the nature of refinanced debt is to continue as recourse debt, consideration should be given to requiring a disclosure from lenders to homeowners who are refinancing,taking out a second mortgage or a home equity line of credit as to the potential tax implications that may occur in the event of a short sale or foreclosure.