Discussion:Principal residence foreclosure (& short sale)

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Discussion Forum Index --> Tax Questions --> Principal residence foreclosure (& short sale)


Neilcpa (talk|edits) said:

21 August 2007
Client bought a home 3 years ago for $ 160,000 and it has remained his principal residence since that time. No improvements have been made to it. He has managed to get a refinanced mortgage up to an amount of $ 190,000 and is six months delinquent in payments. He has a potential buyer of

the house for $ 180,000. The bank says "go ahead and sell the house, we will take the proceeds of the sale and will write off the remaining deficiency." In my narrow minded view, I think that will create cancellation of debt income, and that a better way would be to have the client give the bank a deed in lieu of foreclosure and let the bank make the sale. Then, his deemed sale of the house would be for the amount of the debt and the exclusion would apply. However, the bank does not want to do it this way and says that "it makes no difference how it is done." But, by doing it the bank's way a sale of only $ 180,000 will be created and I don't know how the client can avoid the cancellation of debt income for $ 10,000

What do you folks think of this? Am I just being too conservative or am I just simply wrong?

Taxref (talk|edits) said:

21 August 2007
You would need to check into his other liabilities and assets, but it looks like the potential $10K COD would be offset by insolvency of the same amount.

Dennis (talk|edits) said:

21 August 2007
I believe the distinction has to be made between recourse and non-recourse debt. Recourse debt would give rise to COD income to the extent of solvency, non-recourse would be part of the sales proceeds.

PVVCPA (talk|edits) said:

August 22, 2007
Usually the initial acquisition debt is non-recourse, but any refi debt is recourse. Maybe there is a difference state by state, but this is my understanding in CA.

So if this is true, then you are right. But is it worth the hassle to save the taxes on $10K? Are there other unused deductions that will offset?

Riley2 (talk|edits) said:

22 August 2007
Agree with Dennis about the recourse vs. nonrecourse question. In most states, the mortgage is recourse debt, and a deed in lieu of foreclosure would not change the character of the COD income.

PVVCPA is giving you the correct answer for a California taxpayer. California is unique in that it is an "anti-deficiency" state.

Neilcpa (talk|edits) said:

22 August 2007
Your comments have been most helpful. Thanks much to those who responded.

EZTAX (talk|edits) said:

22 August 2007
Riley2 - What do you mean by anti-deficiency? Thanks.

Mscash (talk|edits) said:

22 August 2007
Given the choices of a short sale that might generate COD income and a foreclosure, the client should consider the value of keeping a foreclosure off his credit report. It may be worth any tax hit.

Riley2 (talk|edits) said:

22 August 2007
EZtax, since you live in California your home mortgage is probably subject to the California anti-deficiency laws. The anti-deficiency laws in California make it virtually impossible for the lender to pursue the borrower for a deficiency on a purchase-money conventional mortgage for small residential properties (one to four units). This rule has the effect of causing most California conventional loans for residential property to be classified as nonrecourse.

EZTAX (talk|edits) said:

23 August 2007
Thanks Riley2!

PVVCPA (talk|edits) said:

August 23, 2007
Riley2 (or anybody else), Would a 2nd DOT taken out at purchase also be covered under CA anti-deficiency laws? Taxpayer did an 80/10/10 at purchase. The lender in the second position has agreed to cancel $30K of debt on a short sale.

JR1 (talk|edits) said:

August 23, 2007
Similar discussion with a client today, and do note that given the high debt to value, there's likely mortgage insurance on this which can cover his missing payments. That's what it's there for. And agree that the COD will apply either way, unless he's insolvent or bankrupt.

PVVCPA (talk|edits) said:

August 23, 2007
I am struggling to find a cite that says that the cancellation of NONRECOURSE debt in a non-foreclosure transaction does not create Cancellation of Debt Income, but instead is treated as additional sales proceeds. Can someone please point me in the right direction?

... Dennis ... Riley2 ... Anyone ... Bueller ....

Dennis (talk|edits) said:

24 August 2007
Reg. 1.1001-2 So long as property is relinquished you are fine. Bank is kind of considered one of the buyers.

Riley2 (talk|edits) said:

24 August 2007
The US Supreme Court held in Tufts v. Commissioner (1983) that the full amount of the nonrecourse debt to which the property is subject must be treated as part of the amount realized.

Regulation §1.1001-2, example 8, illustrates the bifurcated nature of a sale of property subject to recourse debt. In the case of full recourse debt, the amount realized includes debt to the extent of the fair market value of the property. However, under Internal Revenue Code § 7701(g), the fair market value of the property shall be treated as being not less than the amount of any nonrecourse debt to which the property is subject.

Regulation §1.1001-2, example 7, illustrates the proper treatment of nonrecourse debt. In the case of nonrecourse debt, the entire amount of the debt is treated as part of the amount realized, and no portion of the debt is treated as debt cancellation income.

Blrgcpa (talk|edits) said:

24 August 2007
Maybe the home owner can work out a payment plan to pay the $10,000, thus not having a cod.

I've had clients pay the bank the difference between the home selling price, which did not cover the mtge and the balance of the mtge.

Neilcpa (talk|edits) said:

24 August 2007
But, just to expand the discussion a bit; is it not true that in most cases, the home sale exclusion would apply in a foreclosure acting to exclude the gain, subject to the normal limitations?

Larry0434 (talk|edits) said:

24 August 2007
Possibly unforeseen circumstances.

PVVCPA (talk|edits) said:

August 24, 2007
Dennis & Riley2, Thank you very much. Your help led me to:
  • Briarpark v. Commissioner, TC Memo 1997-298
  • Sands v. Commissioner, TC Memo 1997-146

Both of these cases specifically state a single transaction that includes both a discharge of nonrecourse debt and a release of ownership in the property that secured the debt is treated as a sale even though the mortgagee did not take title to the property.

PVVCPA (talk|edits) said:

August 24, 2007
Neilcpa, Yes that would be true provided that the transaction is a foreclosure. However, I am seeing mostly "short sale" transactions, not foreclosures.

JR1 (talk|edits) said:

August 24, 2007
Intriguing, never thought of this. So a foreclosure frees up the COD income as a deemed sale, but trashes the credit rating...Still better to have a fire sale then, with the mortgage company accepting proceeds as payment in full. Does the COD still get tax-free treatment in that case?

PVVCPA (talk|edits) said:

August 24, 2007
I wonder how much MORE trashed an individual's credit rating is with a foreclosure vs a short sale?

I think the debt discharge is considered sales proceeds on a short-sale only if the loan is nonrecourse. Otherwise, it is COD income. And if it is COD income, then you still have a chance to exclude all or some of this income if the taxpayer is insolvent or bankrupt.

Pete123 (talk|edits) said:

6 November 2007
Hi all. I'm seeing a lot of this in San Diego.

1) Any news on when/if HR 3648 will become law? I saw it was passed by the house.

2) Realtor fees and all other closing costs paid by the lender would be added to the actual debt forgiven on the 1099C, right?

3) If your acquistion debt is $500,000 and then you refinance to $550,000, is your acquisiton debt still $500,000? I wouldn't think that you would lose it.

4) Regarding nonrecourse debt, if 70% of the total debt is acquision and 30% is from a second, then would would allocate the 1099C amount as 70% nonrecourse (sales proceeds) and 30% recourse (COD income)?

Thanks for your thoughts.

Pete123 (talk|edits) said:

6 November 2007
Looks like HR 3648 needs to get through the senate. I can't find anytime frame for senate vote. I didn't know that it would change the 121 rules. I guess it had to be revenue netural.

here is a link to a summary of the bill.

http://www.cbo.gov/ftpdocs/86xx/doc8667/hr3648.pdf

Riley2 (talk|edits) said:

6 November 2007
Pete123, the answer to your question #4 depends, in part, on the fair market value of the property.

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