Short Sale Tax Liability and Anti-deficiency ProtectionsLegislative CommitteeThis material is for discussion purposes only and has not been approved by the Legislative or Executive Committees or the Board of DirectorsIssue:
Should C.A.R. sponsor legislation to reduce the “phantom income” tax consequences of short sale debt forgiveness?Action:
OptionalOptions:
1. Do Nothing. Maintain existing law’s anti-deficiency protections that are limited to foreclosures of purchase money mortgages; short sales continue to generate tax consequences.
2. Conform to the recent federal changes. The new federal action is a temporary (3-year) moratorium on taxation of debt forgiveness that does not exceed the owner’s basis in the home. 
3. Pursue permanent or broader protections in California law.   Similar tax changes could be made permanent, or attempt to cover even broader classes of non-purchase money mortgages.
 
Status / Summary:
Short sales and, to a lesser degree, foreclosures, can result in income tax liability to the homeowner for the “phantom” income that is attributed to a borrower by a forgiveness of debt that occurs when aborrower loses his or her home.  Generally, a lender cannot pursue a homeowner beyond the loss of the home.  However, when the borrower escapes some of the debt through the “forgiveness” of a short sale or foreclosure, the forgivendebt is “income” that may generate a tax liability – and work a hardship on the borrower that is already losing his or her home and receiving no cash from the transaction.The Taxation Committee considered this issue in October 2007, anddid not recommend action at the state level, preferring instead to collaborate with NAR on the national level. Since that meeting, the congress has passed legislation to avoid treating the forgiven debt as income, up to the amount of the original loan plus any increased investment in the home. California has not conformed to the new law, but state legislation for at least partial conformity is anticipated in 2008. Discussion
Please see the recently updated C.A.R. legal article (“Q&A”) Taxation of Foreclosures, Deeds in Lieu of Foreclosure, and Short Sales for a detailed explanation of the law, including the newly passed HR 3648.The origins of the “Double Whammy”
The so-called “double whammy” is the imposition of income tax on the “phantom” income of a short sale.The reasoning behind the imposition of tax liability on a homeowner that just lost his or her home and all the equity in it to a short sale is not illogical. At the end of ownership, when the amount of the debt is partially written off at a short sale, there has been income received in the amount of the mortgage debt that was not repaid.The fact that the borrower got no cash in hand at the time (indeed, it is his or her lack of funds and loss of equity that is the whole reason for the short sale) does not change the equation.  In actuality, he or she already got the excess value at the front end of the transaction.The numerical rationale of the troubled borrower’s “windfall profit” is small comfort to the borrower that has just lost both his or her home and all its equity. When the borrower then receives a tax bill in addition, for money he or she didn't get, it seems like the IRS is adding insult to injury.The unexpected tax liability can put the former homeowner so far into insolvency that he or she may never recover enough to buy another home.The Hidden Liability of a Refinanced Mortgage.
California provides special protections for home buyers against mortgage liability, but conforms to the federal interpretations for tax purposes.  Most importantly, a borrower cannot be held personally liable for the purchase money debt – the lender can only take the security (the home) and has no recourse against the borrower.  In a foreclosure sale, since there is no recourse against the borrower, there is therefore no “forgiveness” and thus no attributed income to create tax liability.  The trap for borrowers is that if the original purchase loan is re-financed, it loses its character as purchase money and becomes “recourse” debt that exposes the borrower to so-called “phantom” income (and tax!) from any debt forgiveness. Short sales have an evenharsher rule. There is no distinction between recourse and non-recourse debt – any sale for less than the amount owed, regardless of whether there is personal liability being forgiven, is treated as income.  Paradoxically, this situation actually creates a financial incentive for a borrower with a purchase money mortgage to default and let the property go to foreclosure rather than go through the extra effort of a loan workout or arranging a short sale.The new federal rule
Recognizing thehardship worked on homeowners by the phantom income tax liability, the congress has just passed legislation limiting the imposition of the tax. At the time of this draft, the President is expected to sign the legislation. The new law will create a moratorium on the “double whammy” for taxable years 2007, 2008 and 2009. The new safe harbor rule will apply only to the amount of the original purchase, plus additional debt that was used to increase the borrower’s basis in the house.  By way of a concrete example, if the borrower’s original mortgage was for $500,000 there would be no tax liability for a short sale that forgives any amount of that original debt amount, whether or not it is recourse debt.Should C.A.R. sponsor legislation, or as opportunity presents, an amendment to legislation of others, to conform the California rule to the new federal rule for purchase mortgage debt?In addition, the federal law will avoid tax liability for forgiveness of additional debt that contributes to the borrower’s basis in the property. If our hypothetical buyer borrowed an additional $25,000 against the house to make home improvements (e.g. a new roof) that increased his or her basis in the home, then “forgiveness” ofthat debt would also be protected against creating tax liability.Should C.A.R. sponsor its own legislation, or as opportunity presents, an amendment to legislation of others, to conform the California rule to the new federal rule for debt that builds equity?The new federal rule does not protect against phantom income tax liability for other debt. For example if our hypothetical borrower borrowed an additional $10,000 for consumer debt kinds of expenses (cars, vacations, and college tuition), forgivenessof any of that portion of a mortgage will not be protected from tax as income.  Should C.A.R. sponsor its own legislation, or as opportunity presents, an amendment to legislation of others, to go beyond the federal rule and insulate equity linesof credit and consumer debt from the debt forgiveness rule?Recourse debt and the anti-deficiency rule
A deficiency on a mortgage is the difference between what was collected on the debt from the sale of the security (the foreclosure sale) and what was actually owed.  In other states a lender might first take the house in foreclosure, and then seek a so-called deficiency judgment against the borrower personally for the unpaid remainder of the debt. Absent intentional fraud, that result is unlikely or impossible in California because of multiple borrower protections.First, there is no deficiency allowed in purchase money or seller carry back mortgages. 
Second, even if the note has been refinanced and has become recourse debt on which the borrower can be held personally liable, a judgment for that liability can only be obtained in a judicial foreclosure action.  Effectively all California foreclosures are non-judicial foreclosures utilizing the power of sale built into a note secured by the property.  While it is theoretically possible for a lender to use a judicial foreclosure process instead, the long delays and higher costs of judicial foreclosure make it unfeasible. Finally, other rules prevent a lender from “low-balling” its bid on a property in order to create a deficiencyUnfortunately, even though the conversion of purchase debt to is unlikely to expose the borrower to a deficiency judgment on the mortgage itself, the recourse nature of debt may be criticalto the phantom income tax that may be encountered.Anti-deficiency rules help ensure the quality of loan underwriting as well.   The anti-deficiency rule(s) force a lender to underwrite a loan based completely upon the borrower's credit profile and the collateral (the house) taken as security. If lenders are allowed to look beyond the property actually  being taken as security, and make the decision to lend based upon the borrower's other assets such as other real estate or personal assets, it erodes their incentive to make sure that the property taken as security “pencils out” and is adequate for the loan. As current events demonstrate, there has been no shortage of inadequate underwriting.Should C.A.R. sponsor legislation, or sponsor amendments to bills of others, to expand anti-deficiency protections to the same kind of debt being protected by the new federal law?