Presented by: David L. Rice, Esq. For CalCPA Pasadena Discussion Group 1
Mortgage defaults and foreclosures are of a national concern. In 2011, nearly 5,000,000 borrowers are behind on their mortgage. 2012 could rival 2010 in the number of foreclosures. Many foreclosures have been delayed due to banks having paused as a result of questionable practices. The government entered into a settlement program, but it really won t affect that many borrowers from a percentage standpoint. In 2010, 1 in every 45 households received a notice of foreclosure filing. More than 50% of the foreclosures came from five states and California was one of them. 2
If a home is foreclosed upon, the home owner is treated as having sold the home. From the borrower s perspective a foreclosure, deed in lieu of foreclosure or short sale generally has the same income tax consequences from an income standpoint; however, the types of income recognition can differ. A foreclosure generally creates gain or loss for the home owner and potentially cancellation of indebtedness income (CODI). Different rules apply if a debt is discharged and the borrower does not dispose of the home. 3
With a nonrecourse loan, the home owner is treated as selling the home for the outstanding debt in a foreclosure. In other words, no cancellation of indebtedness income (CODI) will result even if the outstanding debt exceeds the fair market value of the home, even if there is a short sale. See https://www.ftb.ca.gov/professionals/taxnews/2009/july/article_9.shtml http://www.irs.gov/newsroom/article/0,,id=174034,00.html The home owner simply will recognize gain or loss based on the home owner s tax basis (generally purchase cost, plus cost of improvements) in the home. 4
Recourse Debt This is debt for which the taxpayer is personally liable. In the event of a default, the lender can look beyond the collateral pledged for the loan and hold the borrower accountable for the unpaid balance. The lender generally can satisfy the loan with personal bank accounts and other assets of the borrower. Whether debt is recourse or not varies upon state law and the loan documents Non-Recourse debt This is debt where the lender can only look to the loan collateral in the event the taxpayers default on the loan. In California the one action rule as discussed later should not affect the determination whether the debt is recourse or nonrecourse. 5
For example, assume the home owner has a nonrecourse mortgage with an outstanding balance of $250,000, has an adjusted basis of $100,000 and a FMV of $200,000. If the lender forecloses on the home, the home owner would have a taxable gain of $150,000. The home owner could exclude gain of up to $500,000 for a joint return under a principal residence gain exclusion in IRC Section 121, assuming the home owner satisfied the other requirements of that provision. Amount Realized $250,000 Less: Basis $100,000 Gain Realized $150,000 No Gain recognized if IRC Section 121 is applicable. 6
Assume in example 1, above, that the outstanding loan was $250,000, the adjusted basis was $300,000 and the FMV was $200,000. The property will be treated as sold for $250,000, the outstanding debt. The home owner will have a nondeductible loss of $50,000 since the home is a personal use asset. The FMV of the home is irrelevant in determining the income tax consequences. See Treas. Reg. Sections 1.1001-2(b) and 1.1001-2(a)(1) and (a)(4)(i). 7
In this case, the home owner can simply walk away from the loan. The lender issues the taxpayer Form 1099-A, Acquisition or Abandonment of Secured Property. The taxpayer reports the foreclosure on a Form 1040, Schedule D. The taxpayer cannot deduct a loss on the home to offset any income because the loss is from a personal use asset. The home owner does not file a Form 982 because there has been no CODI. 8
If the underlying loan or loans on the property are recourse, then the tax consequences differ dramatically. Most importantly, if the FMV of the property is less than the outstanding debt, the amount treated as paid to the home owner includes that debt only up to the FMV of the property. See. Treas. Reg. Section 1.1001-2(a)(2) and IRS Pub Nos. 544 & 4681. The balance of the outstanding debt generally is CODI. 9
Assume the same facts as in example 2 above, (slide 7), if the underlying loan is recourse, the borrower would have CODI of $50,000, the difference between the FMV of the property ($250,000) and the loan balance on the property ($300,000), assuming no exceptions apply. The home is then considered as sold for the remaining $250,000 debt. This results in a $50,000 loss that the taxpayer cannot recognize due to the home being a personal use asset. Amount Realized: $250,000 Less: Basis $300,000 Loss: ($ 50,000) Absent an exclusion, the CODI of $50,000 should be reported by the lender to the home owner on Form 1099-C. However, caution should be advised as the Taxpayers Advocate Office has reported that taxpayers are receiving incorrect 1099-Cs and lenders resist correcting the problem. 10
In California, if the underlying debt was for a purchase money obligation, then it is nonrecourse. A purchase money obligation means that either: Credit was extended to the buyer by the seller to finance the purchase of property and which is secured by the property; or Funds which were loaned to the buyer by a third party if those funds were used to pay all or a part of the purchase price and the loan is secured by a dwelling of four units or less occupied in part by the borrower as his personal residence. 11
Any other type of debt in California except as enumerated above is recourse debt (unless the loan specifically provides otherwise). As an example, if a home owner refinances his or her home, the debt becomes recourse debt. Home equity loans taken out after the purchase of a home are considered recourse debt. 12
The primary method of foreclosure in California is through a nonjudicial foreclosure sale. The lender waives its right to a deficiency judgment. See California Tax Lawyer, Does a Nonjudicial Foreclosure Convert Debt from Nonrecourse to Recourse (Winter 2011). Under this method a foreclosure sale proceeds pursuant to a power-of-sale contained in a deed of trust. There are very stringent procedures to be followed and any creditor who completes a foreclosure through nonjudicial means is barred from recovering a deficiency judgment against the debtor, regardless of whether the loan is recourse or nonrecourse. CCP Section 580d. However, just because the lender is barred against coming after the debtor, does NOT turn a recourse loan into a nonrecourse loan for tax purposes. 13
In the case of recourse loans, lenders can forego their rights under the power of sale in a deed of trust and file a lawsuit in a judicial foreclosure proceeding. If the creditor prevails, the court will grant a judgment of foreclosure and will direct the sale of the encumbered property and the application of the proceeds to payment of the creditor s costs and indebtedness and the creditor can apply within three months for a deficiency judgment. Upon such application, and establishment of a deficiency, the court will render a money judgment against the debtor for the amount of the deficiency. CCP Section 580a. Remember this procedure does not apply to nonrecourse loans as described above. 14
IRC Section 61(a)(12) provides that gross income includes income from the discharge of indebtedness (CODI), which is taxed as ordinary income. Fortunately IRC Section 108 has a exceptions: IRC Section 108(a) generally provides for the following exceptions: Mortgage Forgiveness Debt Relief Act of 2007. Bankruptcy Insolvency IRC Section 108(e) generally provides for the following exceptions: Accrued, but unpaid interest which is paid would create a deduction Purchase price reduction between buyer and seller for seller financing 15
The Mortgage Forgiveness Debt Relief Act of 2007 (Mortgage Relief Act), extended by the Emergency Economic Stabilization Act of 2008 may save the day for a number of home owners. This section added IRC Section 108(a)(1)(E) which excludes from gross income qualified principal residence indebtedness discharged after 2006 and before January 1, 2013. This section is somewhat complex as there are a number of definitional terms as set forth in the following slides. 16
Qualified Principal Residence Indebtedness is acquisition indebtedness as defined in the home interest deduction rules of IRC Section 163(h)(3)(B), except that total indebtedness is limited to $2,000,000 and not $1,000,000. Under that provision, acquisition indebtedness is indebtedness incurred in acquiring, constructing, or substantially improving any qualified residence and secured by the residence. It also includes refinanced indebtedness if it does not exceed the original acquisition indebtedness. If a refinancing exceeds the original acquisition indebtedness and was used to construct or substantially improve the residence, it too would qualify as would a home equity loan used for such purposes. 17
The term principal residence has the same meaning that it has under the principal residence gain exclusion rules of IRC Section 121. For the residence to qualify as a personal residence, the taxpayer must own and use the residence for at least two out of the five years preceding the sale by the taxpayer. There are a number of other exceptions which should be fully examined. The total amount of principal residence indebtedness that qualifies for relief is $2,000,000. The Act only applies to debt forgive in calendar years 2007 through 2012. The Act does not apply to debts forgiven on second homes, income rental property or commercial property. Must reduce basis by the amount of income excluded This Act was part of Obama s budget to extend to 2014 and perhaps beyond. 18
There is no limit on the amount of relief if the debt is reduced as part of a purchase price reduction of seller financing with the original seller as provided under IRC Section 108(e)(5). Third party lenders do not count. In this instance, a borrower just reduces his or her tax basis in the property by the amount of the debt reduction. This section applies to all types of property and not just personal residences. The exception does not apply in a title 11 bankruptcy or if the borrower is insolvent. 19
California Conformity California only had a modified version of this law, which originally applied only to CODI resulting from foreclosures or short sales in 2007 and 2008 and limited the exclusion to $1,000,000 and not the $2,000,000 as provided for by Federal Law. In April of 2010 the law was extended and applies to all foreclosures or short sales from 2009 to December 31, 2012 and limits the exclusion as follows: $2,000,000 for taxpayers who file as married filing jointly, single, head of household or widow/widower and $1,000,000 for taxpayers who are married filing separately. 20
You can form 540 or 540NR. If the amount of debt relief purposes is the same as or less than California limit, then no adjustment on the 540/540NR is necessary. If the amount of debt relief for federal purposes is more than the California limit, include the amount in excess of the California limit on Schedule CA line 21f. Include the Federal Return and Form 982 with the California return. 21
Ted and Alice, are a married couple who purchased a home in the Inland Empire in 2005 for $450,000. They refinanced the home a year later for $450,000. In 2010, they both lost their jobs and the lender foreclosed on the home, which is their principal residence. At the time of the foreclosure the home had a FMV of $250,000. Because the mortgage was recourse financing, the couple would have CODI of $200,000 ($450,000-$250,000). However, since it was all acquisition indebtedness, it is excluded under the Mortgage Relief Act provisions. To properly report the excluded CODI, Ted and Alice should file IRS Form 982 with their income tax return, IRS Form 1040. On the IRS Form 982, they should check the box on line 1e, report the $200,000 of CODI on line 2, and report $200,000 of basis reduction on line 10b. 22
Assume the same facts in the prior example, except that in 2006 they refinanced the property for $500,000 and spent the cash out on the loan of $50,000 on a gambling trip to Vegas in which the house (not theirs) won. Assume that the FMV of the home at the time of the foreclosure was $300,000. In this example the couple would have $50,000 (Original loan was $450,000 all of which constituted acquisition indebtedness) that would not be excluded under the Home Debt Relief provision and unless one of the following exclusions applied, they would have CODI: Ted and Alice are either insolvent or bankrupt at the time that the debt is no longer owed, which in California is at the time of the non-judicial foreclosure. However, the taxpayer may have to reduce certain tax attributes (NOLs, and capital loss carryovers, tax credit carryovers, basis of property, etc.) Insolvency for CODI purposes means that liabilities exceed assets which is measured at the time of discharge. Exempt assets may count as well as contingent liabilities. The valuation of assets is an issue. 23
Assume Ted and Alice have a basis in their principal residence of $10 million, a FMV of $5 million and a loan balance of $9 million nonrecourse. Assume Ted and Alice default on the loan. The amount realized on a nonrecourse loan is equal to the FMV of the property. Thus the amount realized is $9,000,000 resulting in a loss of $1,000,000 all of which is non-deductible because it is deemed a personal loan. 24
However assume that the loan is recourse and that Ted and Alice default and the lender allows them to do a short sale for $5 million. The amount realized from the sale would be $5,000,000 Ted and Alice will have $4 million of CODI ($9,000,000 - $5,000,000). Of this amount $2 million would be excluded under the Mortgage Relief Act provisions, resulting in $2 million of CODI. The basis of the property would also be reduced by $2,000,000 as a result of the $2,000,000 exclusion above, resulting in a $8,000,000 basis. Thus the couple would have a $3,000,000 non-deductible loss. 25
Assume that Ted and Alice have a nonrecourse acquisition indebtedness loan and a home equity loan against their principal residence. Assume that their basis is $400,000 (original cost), FMV of $300,000 and a home equity line of $150,000, and acquisition indebtedness of $350,000 with the primary lender. Assume the primary lender cancels $50,000 of debt and the equity line cancels $100,000 of debt. If Ted an Alice keep the home, they will recognize $100,000 of CODI from the reduction of the equity line of debt. $50,000 will be excluded from taxable income under the Mortgage Relief Act. 26
Assume the same example above, but that both loans are nonrecourse and the lender forecloses on the home. Ted and Alice will have a gain of $100,000 since the outstanding debt is $500,000 and their tax basis is $400,000. The gain generally could be excluded under the principal residence gain exclusion provisions of IRC Section 121. Even if Ted and Alice paid tax on the gain, it generally should be taxed as preferential long-term capital gains rates. 27
Assume that the loans are recourse and the lenders allow Ted and Alice to do a short sale at the FMV of $300,000. Ted and Alice will have $100,000 of CODI on the acquisition debt discharge, which will be excluded by reason of the Mortgage Debt Relief Act provisions and $150,000 of CODI from the discharge of the home equity debt, none of which will be excluded under that provision, but may be excludible under other CODI exceptions. 28
Ted and Alice purchase a home for $600,000 in cash. Later, Ted and Alice borrow $500,000 on the home equity when the home had a FMV of $700,000. The FMV of the house is currently $400,000. If the lender agrees to reduce the loan by $100,000, Alice and Ted will have $100,000 of CODI. On the other hand what happens if the house is sold? Because the loan is recourse, the amount realized on recourse debt is equal to the FMV of the property. Thus the amount realized is $400,000 resulting in a $200,000 non-deductible loss. However, the recourse note was for $500,000 resulting in CODI in the amount of $100,000 all of which is excluded under the Debt Relief Act of 2007 (note the expiration of 12/31/2012). 29
If the loan was nonrecourse, then the taxpayers would even be better off. The amount realized on a nonrecourse loan would be $500,000 (the amount of the loan). Since their basis was $600,000 the taxpayers would have a nondeductible loss of $100,000 but there would be no CODI. 30
During the past few years there have been a number of cases where the parents are solely on title and on the loan documents but the children purchased the home. Who takes the potential tax hit? In general, a taxpayer my deduct interest or taxes providing he is the one who owes the debt and he makes the payment. In other words the obligation to pay the taxes or interest must fall on the taxpayer. See Treas. Regs. Sections 1.164-1. 31
However, from a tax standpoint, the courts look to the equitable an beneficial ownership as opposed to just legal ownership. Where is the economic effect? The court would look to such items as rights to possession, obtaining full ownership on full payment, who pays the property taxes, who insures the property and who maintains the property. For example, Mom and Dad purchase a home in their name with the intent that it really belongs to their son. The son lives in the residence and makes all the mortgage payments and pays for all other expenses including property taxes. 32
Although Mom is the legal owner, the son is the equitable and beneficial owner and is entitled to the deductions. See Safet and Ana Uslu vs. Comm r, T.C. Memo 1997-551; Adams vs. Comm r, T.C. Memo 2010-72 and Njenge vs. Comm r, T.C. Summary Opinion 2008-84; and Paul Trans and Thuy Bich Dang vs. Comm r, T.C. Memo 1999-233. 33
David L. Rice, Esq. Professor of Accounting David Lee Rice, APLC Cal Poly Pomona 2780 Skypark Drive College of Business Admin. Suite 475 3801 West Temple Avenue Torrance, CA 90505 Pomona, CA 91768 Telephone: 310-517-8600 Telephone 909-869-4597 Email: Drice@lawrice.com Email: DLRice@csupomona.edu 34