Real Estate Finance Committee
May 16, 2009
This material is for discussion purposes only and has not been approved
by the Legislative, Real Estate Finance or Executive Committees or the
Board of Directors
Issue: Should C.A.R. sponsor a change in the law to
expand a borrower's anti-deficiency protections to cover refinanced
purchase monies, and "recourse" junior notes created as part of a purchase,
within the existing protections?
Action: Optional, but necessary if a change is to
become effective in 2010.
Options: 1. Do Nothing.
2. Sponsor legislation to expand anti-deficiency protection to refinanced
purchase money debt.
Status/Summary: C.A.R.'s existing policy supports
application of anti-deficiency rules, and other borrower protections, to
all purchase money financing. C.A.R. also supports insulating real
estate secured debt forgiveness in a sale from being characterized as
income that results in tax liability to the seller. Unfortunately, many
mortgages have lost their characterization as "purchase money" because of a
refinance, or because the purchase financing was divided into two loans and
one or more of them were structured as a recourse or personal note that is
really secured by the property.
Existing Protections from Lenders
First, there is no deficiency allowed for 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; and nearly all foreclosures on
mortgages are via a non-judicial power of sale. Finally, other rules prevent a lender from "low-balling" its bid on
a property in order to create a deficiency.
A purchase money mortgage is "non-recourse," meaning the lender cannot
pursue the borrower for additional liability after a foreclosure. The IRS
has concluded that since the foreclosure sale did not extinguish any
personal liability of the borrower, then there was no debt (that the
borrower could be forced to pay) forgiven and thus there is no income
resulting from a foreclosure. However, the IRS takes a different view
if "recourse" (personal liability) debt is eliminated, and views the
elimination of recourse debt as creating income to the
What if there is a re-finance? There is existing legal
authority that refinancing a purchase money mortgage changes its
character from purchase money to ordinary debt. As such, the
borrower can be subjected to personal liability, not just lose the original
security (the property). This is true even if the same purchase money
balance is re-financed just to get a lower interest rate, and the borrower
takes no equity out of the property.
Fortunately, other protections still apply and it is expensive and time
consuming to pursue the debtor. Also, if the lender takes the
property by non-judicial foreclosure, there still can be no deficiency to
the lender -- but the IRS may still assert a claim of income tax liability.
Should the same borrower protections apply to re-financed
purchase money debt as apply to the original mortgage?
What if there is a junior note? Even worse for the borrower is
a junior note that might be written as a note with personal liability to
begin with, that was used for part of the purchase. Such arrangements
were popularized as "80-20" loans to reduce the need for private mortgage
insurance. They are potentially recourse debt whether or not they have been
refinanced. A junior note will lose its security interest in
the property at a foreclosure sale, becoming a so-called "sold out junior."
However, while the interest in the property has been extinguished,
the underlying debt has not -- and the junior may pursue the debtor that
thought he or she was safe after losing the property in foreclosure. If
forgiven, the recourse debt will result in income to the borrower.
Should junior loans be included in the protections applied to
purchase money mortgages if they were part of the financing or refinancing
of the original purchase?
The "Phantom Income" Tax Liability The IRS has reached the
logical conclusion in foreclosures that if there is no personal
liability (“recourse”) against the borrower, then there is nothing being
forgiven, and thus there cannot be any income imputed from the forgiveness
in the sale. Unfortunately, the IRS has an inconsistent and illogical
position on short sales – even though the purchase mortgage would
still not result in a personal recourse debt. In a short sale,
the IRS treats the extinguishing of a portion of purchase money debt, debt
that isn't allowed to create personal recourse against the borrower, as
income and assigns tax liability.
The illogical distinction between short sale debt forgiveness and
foreclosure debt forgiveness creates a perverse incentive for
borrowers to let a home go to foreclosure rather than work out a short
sale. Public policy should be exactly the opposite, and instead not punish
the borrower that goes to the extra effort to put together a short sale
that avoids a foreclosure, puts another family in a home, preserves the
borrower's credit history and avoids burdening a lender and the market with
a glut of foreclosure properties.
Congress and the California legislature have temporarily dealt with the
issue of attributed income from mortgage debt forgiveness by creating a
safe harbor for a limited window period, but that safe harbor will expire
as early as 2013 at the federal level and even earlier for California
Should C.A.R. recommend to NAR that it pursue a reconsideration
of the rule by the IRS?
What about non-purchase money debt in a refinance?
A "cash out" refinance, one that includes debt beyond the original purchase
mortgage, is essentially taking equity out of the property. This
cashed out equity would normally be appreciation or profit in a sale of the
property and would be treated as income - and taxed. But not all cash
back refinances are taking profit out of a property. Some are bona
fide home improvement loans, and actually increase the borrower's basis in
The new (but temporary) federal law recognizes the logical distinction, and
distinguishes between the cash-out refinance that funds a new roof or a
room addition (thus increasing the borrower's tax basis), and the cash that
is taken out for unrelated purposes like a vacation trip or consumer
purchases. Only the new debt that contributes to the basis in the property
is protected. This seems to be a logical distinction that should logically
be included in any change in the California law that expands the protection
extended to purchase money mortgages.
What Other Arguments Support Expanding Purchase Money Protections in a
First, it's fair. Home buyers, and lenders, entered into the purchase
with the idea that the mortgage would be non-recourse debt, and that the
lender would look to the security (the house) itself to make good on the
debt if the borrow cannot. It meets the legitimate expectation of the
borrowers, who have no idea that they are losing this protection by a
refinance. Home owners seem uniformly unaware that their refinance will
expose them to personal liability and new tax liability on the note. It
would be unfair to allow a lender, or someone that has purchased a note
from a lender, to pursue the borrower beyond the value of the agreed upon
Second, Anti-deficiency rules help ensure the quality of loan
underwriting. Expanded anti-deficiency rule(s) will force a lender to
underwrite a (refinance) loan at least as carefully as a purchase money
mortgage. 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 loan "pencils out" and has
adequate security. As current events demonstrate, there has been no
shortage of inadequate underwriting. As over extended lenders become more
desperate to salvage their loan portfolios, we may see attempts to pursue
borrowers in judicial foreclosure and seek deficiency judgments.
Doesn't the new federal law (HR 3648) already deal with the tax
problem? Only for a limited time. The new federal law
doesn't change the actual underlying legal problem for "forgiven" debt and
taxation of "phantom" income, it only forebears imposing liability on such
a situation for three years. After the sunset, the underlying problem
will still remain.
Maintaining the basic purchase money character of the original debt will
invite the IRS to reconsider its current illogical position on refinanced
mortgages. While California cannot change the federal rules with a
state statute, it can change the underlying remedies available to
a lender, and thus effect the logical foundation for the current IRS
Should C.A.R. sponsor the expansion in borrower