Debt and Income Tax for Foreclosed Homeowners
Due to increasing monthly
payments, declining real estate values and other reasons, many Arizona
homeowners face the prospects of letting their homes go by foreclosure.
This article deals with a homeowner’s liability if the house is resold
for a price that is less than the loan balance, a situation that is
known as a “deficiency.”
The good news for most
borrowers is that Arizona has anti-deficiency laws – specifically, A.R.S.
33-814(G) – that prohibit purchase-money lenders (explained below)
from collecting on a deficiency. However, the bad news is that the
anti-deficiency protection often does not apply to second mortgages,
equity lines of credit, some refinanced loans, etc. In those exceptions,
generally the only relief is achieved through bankruptcy.
Names. In the
great majority of cases, mortgages on Arizona residential properties are
not mortgages at all; to use the more accurate term, they are “deeds of
trust.” Almost all deeds of trust are “foreclosed” upon not by
foreclosure actions but by “trustee sales” that allow lenders to
expedite the process without filing a lawsuit. (There are residential
foreclosure actions that involve a lawsuit filed with the Superior
Court, but they are rare.)
Now that we have defined our
terms, let’s revert to words with which you may be more familiar. For
the rest of this article, unless otherwise stated, we will frequently
use “mortgage” and “foreclosure” in place of, respectively, “deed of
trust” and “trustee sale.”
If a homeowner
falls significantly behind in making payments, the lender will instruct
its trustee to foreclose on the deed of trust. The foreclosure is
commenced by recording with the County Recorder a “notice of trustee
sale” that states the date, time and location of the sale. The sale date
can be no sooner than 90 days after the notice of trustee sale is
recorded. The trustee sends a copy of the recorded notice of trustee
sale to the homeowner and any other parties (e.g., lenders) that have an
interest in the property. The notice of trustee sale is sent by
certified mail and, in some cases, is posted on the property.
If the homeowner fails to bring
the mortgage current by the sale date, the trustee will hold an auction
sale at the location, date and time specified in the notice. The first
bidder is the first lender, which bids the unpaid loan amount and
accrued interest. It is rare for there to be any other bidders. Upon the
close of bidding, the property is transferred to the lender (or other
successful bidder) by trustee deed. Because most lenders are more
interested in being paid than in owning foreclosed real estate, the
lender will try to expedite the sale of the property.
In a period of
depressed real estate values, it is not uncommon for foreclosed
properties to be worth less than the mortgage balance owed. For example,
a lender forecloses on a property that has a $250,000 balance on the
lender’s purchase-money loan. After acquiring the property at a trustee
sale, the lender sells it for $200,000, creating a deficiency of
$50,000. Even though the loan documents include the borrower’s promise
to repay the loan, the lender cannot take legal action to recover the
deficiency if the loan was used to purchase the residence.
To qualify for anti-deficiency
protection, the residence involved need not be the homeowner’s
residence. It need only be, per the statute, a “parcel of real property
of two and one-half acres or less which is limited to and utilized for
either a single one-family or single two-family dwelling.”
v. Non-purchase Money.
The mortgage used to finance
the purchase of the house is a purchase money security interest and is
uncollectible after the foreclosure. A second mortgage may also qualify
as a purchase money loan if it is also used for the initial purchase of
the residence. Examples of purchase money second mortgages are
carry-back notes from the seller or the “20" of an “80/20" loan.
Any mortgage where the money is
not used to buy the house is a non-purchase money security interest.
Examples include home improvement loans and home equity loans. To the
extent that there is a balance on these loans after the foreclosure
sale, the balance is not extinguished by the foreclosure. The lender has
recourse against the homeowner, by collection and, if need be, by
There is an unresolved issue as
to refinanced loans that include the purchase money loan(s) and involve
additional borrowing such as pay-offs of second mortgages. While a court
Bank One v.
the view that mortgages that include the original purchase money loan
are subject to the anti-deficiency laws, there are differences of
opinion as to that decision’s applicability. From a practical
standpoint, once the homeowner has made payments on the mortgage, the
lender will be unable to distinguish between payment toward the portion
of the loan that is the purchase money loan and payment towards the
portion of the loan that is for the rest of the loan.
To preserve its right to
recover a deficiency, the lender will need to bring an actual
foreclosure lawsuit. As set out above, this is rare event and takes
longer than a foreclosure by trustee sale.
Forgiveness as Income.
Notwithstanding the issue of
anti-deficiency protection, the loss of a residence is not necessarily
the ultimate consequence of a foreclosure, as cancellation of debt can
trigger a crushing tax liability.
If a lender cancels a debt, the
lender is obligated to send to the borrower and the IRS a “Form 1099-C:
Cancellation of Debt” for the year in which the debt is cancelled. The
resulting cancellation of debt may be taxable as ordinary income to the
anti-deficiency statutes, the Internal Revenue Code and the Mortgage
Forgiveness Debt Relief of Act of 2007 offer various exceptions for
taxpayers who have received a 1099-C.
One exception pertains to
“non-recourse” debt, in which the loan documents specifically state
that, in the event of a deficiency, the lender would have no recourse
against the borrower. In Arizona, many residential loan documents have
recourse provisions (i.e., they theoretically preserve the lender’s
right to pursue the borrower for a deficiency). However, the state’s
anti-deficiency statutes render those recourse provisions ineffective.
Whether the statutes render as “non-recourse” a loan agreement that
contains recourse language is another unresolved issue, and the
borrower’s tax liability may depend on the IRS’s interpretation.
(Other exceptions to the
taxability of cancelled debt include bankruptcy and insolvency on the
part of the borrower at the time the loan was cancelled.)
The Mortgage Forgiveness Debt
Relief of Act of 2007 remedies some of these issues. The Act applies to
transactions after January 1, 2007, and before January 1, 2010, and
permanently excludes debt forgiveness from income if (a) the real
property was the principal residence of the taxpayer; (b) the debt was
for the purchase, construction or substantial improvement of the
foreclosed property; and (c) the foreclosed property was the taxpayer’s
primary residence for two of the past five years.
Conversely, the Act’s
protections do not apply if (a) the property did not qualify as the
borrower’s principal residence or (b) in refinancing the first mortgage,
the borrower used part of the loan proceeds for purposes unrelated to
the property (e.g., an auto purchase, payment of college tuition,
consumer debt repayment, etc.) The last provision again raises the
challenge of distinguishing the purchase money portion from the
non-purchase money portion.
One last tax consideration in a
foreclosure is whether the residence had been used for a business
purpose, such a rental or for a home office, and there has been
depreciation claimed in past years. The foreclosure could cause a
capital gain because of the past depreciation.
and Deeds in Lieu.
With an eye to minimizing the
credit damage that a foreclosure can cause, a homeowner may consider
alternatives, such a “short sale” or a “deed in lieu of foreclosure.”
In a short sale, a borrower
can, with the lender’s approval, enter into a sale of real property for
less than the amount due on the loan. If the lender forgives the
shortfall, the cancellation of debt could result in taxable income. To
avoid that consequence, the borrower might give the lender a promissory
note for the balance.
A deed in lieu of foreclosure
is an agreement between the borrower and the lender that the borrower
deeds the property to the lender in satisfaction of the outstanding
debt. The “canned” language of such an agreement almost always provides
that the value of the property is equal to outstanding obligation,
thereby allowing the borrower to escape any tax liability arising from