Cancellation of 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. §§ 33-729(A) and 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.

The Right 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.”

The Process. 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.

Deficiency. 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.”

Purchase Money 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 lawsuit.

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 decision in Bank One v. Beauvais supports 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.

Debt 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 taxpayer.

Fortunately, Arizona’s 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.

Short Sales 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 cancelled debt.