Legislative Committee
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.
3. Other

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.

Discussion:
For additional information please see also the C.A.R. Legal Q&A article "Foreclosures and Short Sales" at http://www.car.org/legal/legal-questions-answers/legal-articles-by-category/

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 debtor.     

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 taxes.

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 property.

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 Re-finance?
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 security.

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 analysis.

Should C.A.R. sponsor the expansion in borrower protections?