Deed in Lieu- short vs Foreclosure - Taxes

[greybeard411]

Hi
I'm new here; I'm up here in Auburn, Ca. - I have read for many days and learned alot. Thank you to all!
I have many questions that i still need to ask because after a week of reading here-there-and everywhere I am still
bogged down in confusion over so many issues.
My story:
I personaly am doing ok and not in foreclosure. The reason I am looking into this is for my daughter and husband who
have decided foreclosure/short sale/ deed in liue/ walk away/ are their options at present.

They have a 250k purchase money 1st only; 40 year/ interest only for 10 years - then the payment goes UP- no money
down - no seconds or any other loans on it with Citimortgage. They bought 2 years ago (2007). They still owe the
whole 250k. (We have put about 5k into it remodeling over 2 years; labor was free the kids make aprox 62k a year
together so they are in the 15% fED TAX BRACKET; AND from what i have read- in the 9.3% tax bracket for california
State.(?)
The property value (Rio Linda) has dropped. Plummetted. There are 3 houses on their street now for Under 80k. There
is one condemned home on street. A gang of ruffians/thieves/ have gathered at one end of street and crime and
vandalism are occuring . The comps on the area appear to be down around 120 and lower. (although zillow lists their
home at 183k).
Last month the kids filled out papers for some kind of adjustment - apparently tacked on at the end of the loan- in
which WHILE they are being evaluated the lender reduced their payment 300 dollars for the next 3 mpnths until they
are told weather they qualify. They have not spent the 300 for this month in case they have to give it back. Even at
the 300 reduction they've determined they can't make it. They have a new wonderous! 2 month old baby - hospital
Bills came in - Insurance policy increased - doubled- resulting in even less take home pay- and now there will also
be Daycare costs etc. that just were not factored in.
They looked around at the deterioration of the nieghborhood - the crime and vandalism for the last year - and said-
there is no way our baby is growing up here.
We have spoken to an attorney suppossively versed in real estate and foreclosure. Unfortunately, the 225 dollar an
hour attorney: didn't know that the Mortgage Relief Act (MRA) had been extended beyond 2009 until 2012.
Didn't know that california tax law was different than the federal Act. Didn't know that the california tax relief
ended in 2008...She had to email another attorney who verified what i said. She then indicated that the worse case
senario would be the difference between the mortgage (250k) and the nieghborhood value (120k) so there would be a
worst case 15% tax owed on 130k........
Yet, I continue to read that cancellation of debt income (forgiveness) is not taxable in the case of non-recourse
loans.(?) then, I read that it is.
so as you can see we are still very confused how an underwater defiency in california is taxable at all.(?)

I found that there is one Bill, AB111, (due for vote -or committe on may 4th) to extend the california tax problem
that ended in 2008 to 'conform' with the federal MRA until 2012. However, Then there were 2 amendments that changed
this Bill til January 1, 2010 (instead of 2012).
There also is another Bill to conform to MRA (with a couple exceptions) in the Senate to extend tax relief til 2012
- SB 97 - Calderon - http://www.ftb.ca.gov/law/legis/09_1...b97_012609.pdf
It has not been scheduled as yet; and I saw no amendments.
The lady i spoke with at (Assembly Niello's office i think it was) thought the AB111 Bill would pass for 2009. She
didn't KNOW, but thought it was likely.
If the kids began foreclosure next month we are concerned that the process will take longer than the balance of this
year and extend into 2010 where AB111 will not cover. None of us, even together, have $12,000 for a 9.3%(?) tax
Bill. (Tho we understand perectly it's much better than a recoursed 125K+ Bill!)
We also can't figure out weather to go right to foreclosure (by them not making next months payment) because of this
year end time constraint (should AB111 pass for 2009) or, do as the attorney suggested and 1) immediately put it on
market at a short sale price and if an offer comes in, wait for the lender to reject it - and when rejected, ask for
a deed in liue of foreclosure........this attorney said write a letter to make the lender think it's beneficial to
them and cost effective to do so------somehow --- without actually asking for the 'deed in leui of-".
I read many various conclusions as to the outcome to hits on credit depending on what form of walk-away is chosen-
short sale is better than deed in luie- deed in luie better than foreclosure - yet on FICO.com itself they have a
page that says there is relatively ZERO difference to CREDIT. NONE.
The basic difference is only the number of YEARS one Might be able to qualify to purchase a home again depending on
which option you proceeded with - at HIGHER interest rates - probable Mortgage insurance - 20% down -etc. (The
attorney told the kids- oh yeah you'll be eligible again in 2 years - but i have since read that 2 years is ONLY for
short sales(?) - and that even Fanniemae has changed their rules and have increased the number of years to qualify
according to which proceedure you used; AND that all future loan apps will have a "Have you ever had a
foreclosure..." question on it)

1) Since the kids still qualify federaly under MRA wouldn't the tax for Cal. state only be 9.3%? and not 15%?
2) I also read that people in the 10-15% FED tax bracket are actually only taxed @ FIVE percent on capital gain-(why
do we feel we wasted 225 dollars)
3) and i guess that's my other question - if a cancelation of debt foreclosure on a non-recourse loan is not taxable
- is the difference considered instead to be "GAIN/loss/?" (If it is not taxable- then why all these Tax Relief
Bills- it's very confusing)
4) If the difference is considered Gain/loss, rather than forgiven debt, then wouldn't the 250k(single)-500,000
(married) Capital gain/loss exemption kick in- and no tax owed anyway?
If anything at all is taxable as 1099 income for any reason- would not the exemption work for the calif tax beyond
the 2009 AB111 tax relief Bill?
thank you for this forum- and thank you in advance for your consideration in answering these multitude of questions.
I'm sure to have a few more

[knownick]

Welcome to the site, I'm also new here and your neighbor from down the hill.

I don't have direct answers to your questions, but I believe that insolvency also precludes you from being liable for a big tax bill. Do your kids have substantial assets that would cause them to not be able to prove insolvency?

It's my understanding that most people this upside-down on their houses and entertaining foreclosure as an option generally don't have a hard time proving they are insolvent at the time the debt was forgiven.

Good luck to you and your kids.

[The Professor]

Welcome Greybeard411:

By way of introduction I teach about 11 miles from you. Today, that is all I do, but as evidenced by the grey hair on my head, coupled with the fact that I handled my first foreclosure something like 35 years ago (seems like yesterday), I try to share my experiences and knowledge on this Board in hopes that I can give back in some way as a balancing act for the way I exercised creditor remedies during past downturns.

As to the tax liability, my sense is the legislature will come through with an appropriate extension, particularly in light of the fact that there is a new wave of foreclosures on the move here in California that won't be completed by December 31st. However, on at least one thread in this forum, we "beat to death" a discussion about the tax ramifications of a foreclosure on non-recourse debt (through CCP Section 580b), and reached pretty much a conclusion that the IRS seems to have acknowledged that there is no forgiveness since no personal debt is owed. You can search the past threads, and I'll invite others who participated in that discussion to join in.

Frankly as I've shared in the past, my area of comfort is talking about foreclosure processes and the laws relating to them. Tax law, because it isn't intuitive and favors transactional form over substance, is just too challenging to gain a handle on.

That being said, I did find one online source that reaches the same conclusion (that is "no forgiveness of debt tax liability on foreclosure of non-recourse debt). I've quoted it below.

Take care,

Daniel

How are foreclosures (and deeds in lieu of foreclosure) taxed?

An important consideration in the results of a foreclosure (or a deed in lieu of foreclosure) is whether the debt is "recourse" or "nonrecourse". If the debt is "recourse", the debtor is personally liable for the debt. If the debt is "nonrecourse", the debt is only secured by the property, and the debtor is not personally liable for the balance.

You should consult with an attorney to determine the status of your mortgage. In California, most mortgages that are used to purchase a residence are nonrecourse, but mortgages from refinancing a previous mortgage are usually recourse.

When a nonrecourse mortgage is foreclosed, the property is treated as being sold for the balance of the mortgage. (G. Hammel, SCt, 41-1 USTC ¶ 9169.)

[greybeard411]

Hi
thanks for replies nonick n Professor!

The more I read the more unanswered questions i scratch my head over.

I still wonder IF the difference of the loan/ and what the fair market value/or / what it is sold/ auctioned for/ [say 125k difference] if that foreclosed taxable difference (for california) can be wiped out by using the 250k-500k capital gain exemption.?

I also found a calif law yesterday that i wonder if I am interpting correctly to mean that if a nieghborhoods value has gone down that a principal reduction
is mandatory...California Civil Code 2923.6

Practically all residential mortgages have Pooling and Servicing Agreements (“PSA”) since they were transferred to various Mortgage Backed Security Trusts after origination. These vehicles likewise almost always contain a duty to maximize net present value to its investors and related parties. Under the new laws, California Civil Code 2923.6 broadens and extends this PSA duty by requiring servicers to accept loan modifications with borrowers.

Essentially, California Civil Code 2923.6(a) states that “a servicer acts in the best interest of all parties if it agrees to or implements a loan modification where the (1) loan is in payment default, and (2) anticipated recovery under the loan modification or workout plan exceeds the anticipated recovery through foreclosure on a net present value basis.”
Likewise, California Civil Code 2923.6(b) now provides “that the mortgagee, beneficiary, or authorized agent offer the borrower a loan modification or workout plan if such a modification or plan is consistent with its contractual or other authority.”

(.......on a net present value basis)

the kids loan as stated above is 250k
I had comps sent to me yesterday- and the nieghborhood is worse than I figured. The Comps are between 69k -to 80k!

Foreclosures typically cost the lender $50,000 per foreclosure. For example, the Joint Economic Committee of Congress estimated in June, 2007, that the average foreclosure results in $77.935.00 in costs to the homeowner, lender, local government, and neighbors. Of the $77,935.00 in foreclosure costs, the Joint Economic Committee of Congress estimates that the lender will suffer $50,000.00 in costs in conducting a non-judicial foreclosure on the property, maintaining, rehabilitating, insuring, and reselling the property to a third party. Freddie Mac places this loss higher at $58,759.00.

If I were to subtract the cost of foreclosure @ 50k and the value of the current market comped value of apr 80k - the asset would be worth 30k after a foreclosure---? yes?

under this law is the lender is NOW REQUIRED by this new code to modify the loan so it's investors do not lose money on a home going into forecloser allowing a borrower to present his/her OWN offer of modification plan?

Modification Offer to Lender:
a) New Loan Amount:$50,000.00
b) New Interest Rate: 5% fixed
c) New Loan Length:30 years
d) New Payment:$268.41

The recovery to the lender and investor/s would be $20,000
Do I interpet it correctly, the LENDER MUST EXCEPT this Loan offer because recovery under the loan modification or workout plan exceeds the anticipated recovery through foreclosure on a net present value basis.”

??

thank you for any info on this subject - avoiding foreclosure and credit smashed with this option, allowing them to sell it, would be great!

[mpfxtrader]

GreyBeard411,


It looks like even if AB111 will not be passed we can still minimize taxes on Cancellation of Debt (COD) through insolvency per this article.

There's really two possible tax events that can happen in case of foreclosure, short sale or DIL. One is the cancellation of debt and the other is the gains from foreclosure itself. You have to treat each event separately.

As always, you should seek an advise from a lawyer to be sure.