Non Judicial Foreclosures, the Process:
STEP ONE - NOTICE TO CURE AND INTENTION TO ACCELERATE
Generally, Borrower/Owner has missed between 1-3 months of payments.Lender sends letter demanding payment.Sometimes Lender will not send this letter and just go to Step Two.Under certain cases Request for Special Notice must be filed pursuant to Civil Code §2924b(a)
STEP TWO - NOTICE OF DEFAULT AND ELECTION TO SELL UNDER DEED OF TRUST (Civil Code §2924c)
Borrower/Owner did not pay full amount due and owing.Lender Records a Notice of Default and mails Borrower/Owner a copy by regular and certified mail. Lender is also required to give notice to any party who has recorded a Request for Special Notice. Substitution of Trustee may also be recorded at this time.
STEP THREE - NOTICE OF TRUSTEE’S SALE (Civil Code §2924f)
At least 3 months have passed since Notice of Default was recorded, and Borrower/Owner did not pay the entire past due amount.Lender records the Notice of Trustee’s Sale and mails Borrower/Owner a copy.Sale is set at least 20 days after recording the Notice of Trustee’s Sale.
STEP FOUR - FORECLOSURE SALE (Civil Code §2924h)
STEP FIVE - NOTICE TO QUIT (EVICTION NOTICE)
New owner has recorded the trustee’s deed upon sale.Borrower has 3 days to vacate after getting Notice to Quit.
STEP SIX - UNLAWFUL DETAINER (EVICTION)
Borrower receives Summons and Complaint.Borrower has 5 days to answer or risk default.Trial set within 21 days of service of Complaint.
STEP SEVEN - LOCK OUT BY SHERIFF
Sheriff will post 5 day Notice to Vacate.Borrower locked out on or after posted date.
Note in California: Under California's Perata Mortgage Relief Act (Civil Code § 2923.5 et seq.), applicable to loans secured by owner-occupied residential real property containing no more than four dwelling units and recorded from January 1, 2003 to December 31, 2007, lenders (mortgagees, trustees, beneficiaries or their agents) may not file a notice of default until 30 days after (i) initial contact with the borrower; or (ii) satisfying statutorily-mandated “due diligence” requirements for contacting the borrower. (See Civil Code § 2923.5(a),(g),(i)--"owner-occupied" means borrower's principal residence "as indicated to lender in loan documents" ; Mabry v. Super.Ct. (Aurora Loan Services) (2010) 185 Cal.App.4th 208) Before filing a notice of default, the lender must contact (or attempt to contact) its borrower in person or by telephone to assess the borrower's financial situation and explore options for avoiding foreclosure. During the initial contact, the borrower must be advised of his or her right to request a subsequent meeting and, if requested, the lender must schedule the meeting within 14 days. (Civil Code § 2923.5(a)(2)-- the lender must provide the borrower with HUD's toll-free telephone number for purpose of finding HUD-certified housing counseling agency at initial or subsequent meeting; see also Mabry v. Super.Ct. (Aurora Loan Services), 185 Cal.App.4th 208)
|Day 1||Record “Notice of Default”|
|Within 10 Days||Within 10 days of recording the Notice of Default, copies of the recorded document (NOD) are mailed to the Borrower(‘s) and anyone requesting Special Notice.|
|Within 1 Month||Notice of Default is mailed to parties, pursuant to California Civil Code 2924(c)|
|After 3 Months||At the end of 3-month, pre publication period, the Lender can then instruct the Trustee to set a sale date|
|At Least 20 Days Prior to Sale Date||Publish Notice of Sale, post Notice of Sale, mail Notice of Sale.|
|Within 10 Days from first publication of Notice of Sale||Send beneficiary request|
|14 Days Prior to Sale||Record Notice of Trustee's Sale|
|5 Business Days Before Sale Date||Right to Reinstate expires|
|Sale Date||The property sale is postponed to a new sale date or the property is sold to high bidder, or the property reverts to the foreclosing beneficiary|
POSSIBLE TAX CONSEQUENSES
It has been some time since the real estate industry, on a large-scale basis, has had to deal with foreclosures, deeds in lieu of foreclosure, short sales and other distress sales of real property. Unfortunately, distress sales of real property, resulting from a convergence of tightening credit, falling property values, and the consequences of prior lending practices, are all too common currently and do not appear likely to end any time soon.
Seemingly adding insult to injury, owners of real property facing a distress sale, and generally already under financial strain, may be unpleasantly surprised to learn that two types of taxable income can result from a foreclosure, deed in lieu of foreclosure, or short sale: capital gains and forgiveness of debt (cancellation of debt) income. Both types of income can trigger unexpected taxes for the owner.
TAXATION OF FORECLOSURES OR DEEDS IN LIEU OF FORECLOSURE
This legal article discusses the income tax consequences to the borrower in the event of foreclosure, the event the borrower simply transfers title to the lender (deed in lieu of foreclosure), and if the borrower sells the property to another in a short sale in which a lender accepts less than the balance due on the loan as payment in full.
Q 1. Are foreclosures, deeds in lieu of foreclosure, and short sales subject to federal tax income taxation?
A. Yes. However, the income is taxed differently depending on several factors, including whether there was a foreclosure, a deed in lieu of foreclosure given to the lender, or a short sale (a sale where the lender agrees to reduce the amount owed in order to facilitate a sale), and whether the underlying debt is ?recourse? (the borrower is personally liable for the debt) or ?nonrecourse? (the borrower is not personally liable for the debt).
For federal income taxation as a result of foreclosure, see generally 26 U.S.C. §§ 1001 through 1016. For federal income taxation of short sales, see generally 26 U.S.C. §§ 61, 108 and 1001 through 1016.
Q 2. What is the difference between a foreclosure and a deed in lieu of foreclosure?
A. A foreclosure refers either to a trustee's sale foreclosure (not a judicial proceeding) or to a judicial foreclosure (a judicial proceeding). A deed in lieu of foreclosure means that the lender has agreed to accept title to the property and the borrower transfers title to the lender rather than waiting until the lender forecloses on the property. A deed in lieu of foreclosure is not a special instrument. It is simply a conveyance of the property to the lender by grant deed or quitclaim deed; and, in exchange, the lender cancels the promissory note secured by the real property. In this way the lender can avoid the foreclosure process to regain title to the property.
However, a borrower cannot simply transfer title to the lender without the lender's permission. Because some lenders have refused to negotiate and accept the deed in lieu of foreclosure, some creative homeowners have quitclaimed the property to the lender anyway, and have recorded the instrument without the lender's permission.
In 1993, the California legislature passed a statute to protect lenders from involuntary (and invalid) transfers of real property to the lender. The lender must record a "notice of nonacceptance of a recorded deed" in the county where the real property is located. Redelivering a grant of the real property back to the original homeowner (e.g., borrower) does not legally retransfer the title. (Cal. Civ. Code § 1058.5.)
A lender may not want to take a deed in lieu of foreclosure because taking title in this manner does not extinguish any junior liens. A foreclosure by a senior lienholder essentially wipes out all junior liens.
Q 3. How does the owner receive "income" from a foreclosure or a deed in lieu of foreclosure?
A. A foreclosure proceeding, whether through a trustee sale or judicial foreclosure, and a deed in lieu of foreclosure given to the lender are treated the same as a sale for income tax purposes. The foreclosure or deed in lieu of foreclosure is reported on the taxpayer's tax return as a sale or exchange in the year the foreclosure is finalized or the deed in lieu of foreclosure is given to the lender.
In a foreclosure or deed in lieu of foreclosure, the owner can receive "capital gain or loss" as in any other sale of real property (i.e., be subject to capital gains taxation or receive a credit for a capital loss). Additionally, the owner can receive "forgiveness of debt" income. This is also referred to as "cancellation of debt" income. Whether the owner is subject to taxation on this income may depend on whether the debt is "recourse" or "nonrecourse." If the debt is a recourse debt, the owner may be deemed to have received taxable income in the amount of debt that is forgiven by the lender (except in certain situations discussed below where the owner will not be taxed). If the debt is nonrecourse debt, there is no taxable income from forgiveness (or cancellation) of debt, but the owner may be still be subject to capital gains taxation.
Q 4. What is "nonrecourse" debt?
A. Under California law, a debt is considered "nonrecourse" when a loan is made under either one of the following two circumstances:
- When the loan is made to purchase a one-to-four unit property and the borrower intends to occupy at least one of the units, or
- When the seller carries back financing for all or a portion of the purchase price of any real property. (Cal. Code Civ. Proc. § 580b.)
In the event of default by the borrower, the lender, or financing seller, is restricted to recovering the property with no right to proceed against the borrower for any deficiency should the property be worth less than the loan amount.
Q 5. What is "recourse" debt?
A. Under California law, a "recourse" debt is one in which neither of the two exemptions in Question 4 occurs.
Examples of recourse debt are refinances of existing mortgages, home improvement loans, equity lines of credit, and loans other than seller financing, securing a debt for purchase of property that is not an owner-occupied one-to-four unit property. The lender is not limited to taking the property back and the borrower may be personally liable on the debt. If the lender chooses to foreclose using a trustee's sale, then the lender waives the right to go after the borrower for the deficiency despite the fact that the loan was a recourse debt. In order to go after a deficiency judgment, the lender must go through a judicial foreclosure process.
Q 6. How is the amount realized (taxable income) calculated for a "recourse" debt in a foreclosure?
A. If the debt is recourse debt, meaning the owner may be personally liable for the debt, the amount realized is calculated in a two-step approach.
First, you take the difference between the Fair Market Value (FMV) of the property (usually the sales proceeds at the judicial foreclosure or trustee's sale) and the Adjusted Basis in the property. Generally, the Adjusted Basis consists of the purchase price of the property plus any capital improvements (less depreciation, if the property is investment property). This difference is the capital gain or loss. If the FMV exceeds the amount of the Adjusted Basis, then the borrower has realized a capital gain at the time of the transfer (foreclosure). If the Adjusted Basis exceeds the FMV, then the borrower has a capital loss.
Second, you take the difference between the amount of the cancelled debt (e.g., unpaid loan amount) and the sales proceeds at the foreclosure (FMV). This is the forgiveness of debt (cancellation of debt) income and it is treated by the IRS as ordinary income despite the fact that the borrower has received no cash at the time of the foreclosure.
However, if the cancelled debt amount is considered "qualified principal residence indebtedness" pursuant to the Mortgage Forgiveness Debt Relief Act of 2007, there will be no taxation on this forgiveness of debt (cancellation of debt) income. See Question 9 for a definition of "qualified principal residence indebtedness."
The unpaid balance of the loan is $300,000;
The FMV of the property is $250,000;
The taxpayer's adjusted basis in the property is $200,000.
Assume the lender forecloses and will forgive the underlying debt.
FMV ($250,000) less taxpayer’s adjusted basis ($200,000) results in capital gains for the taxpayer.
FMV $250,000 Less Adjusted Basis $200,000 Capital Gains $ 50,000
Amount of cancelled debt (amount owed on $300,000 loan) less FMV ($250,000) is ordinary income to the taxpayer.
Amount Owed 300,000 Less FMV $250,000 Ordinary Income $50,000
Note: If a lender chooses to foreclose through a trustee's sale and is barred from obtaining a deficiency judgment by the one action rule under California Code of Civil Procedure Section 580d, it is likely the IRS will still consider that the underlying debt as a recourse debt and it will be subject to debt forgiveness income. (See Rev. Rul. 90-16.) However, there may be no taxation of this income under The Mortgage Forgiveness Debt Relief Act of 2007.
If the FMV at the foreclosure sale is more than what the lender is owed, there will be no forgiveness of debt and, thus, no ordinary income to the taxpayer.
1. The unpaid balance of the recourse debt is $300,000;
2. The FMV of the property is $400,000;
3. The taxpayer's adjusted basis in the property is $200,000.
FMV ($400,000) less taxpayer's adjusted basis ($200,000) results in capital gains for the taxpayer.
FMV $400,000 Less Adjusted Basis $200,000 Capital Gains $200,000
The debt is fully paid (since the FMV of $400,000 exceeds the unpaid loan amount of $300,000) resulting in no forgiveness of debt.
Q 7. How is the amount realized (taxable income) calculated for a "nonrecourse" debt in a foreclosure?
A. If the debt is nonrecourse, meaning the owner is not personally liable for any deficiency (beyond the value of the property), the amount realized is the difference between (a) the greater of: (i) the FMV or (ii) the entire outstanding debt; and (b) the adjusted basis of the property.
This amount is treated as capital gains and there is no taxation for forgiveness of debt income. Even though the adjusted basis might exceed the FMV and the outstanding debt, generally no capital loss would be allowed because nearly all nonrecourse debt is associated with a principal residence. (Capital losses are applicable only to investment property.)
1. The unpaid balance of the loan is $300,000;
2. The FMV of the property is $250,000;
3. The taxpayer's adjusted basis in the property is $200,000.
Greater of FMV ($250,000) or entire unpaid debt ($300,000) minus taxpayer's adjusted basis ($200,000) results in capital gains to the taxpayer.
Greater of FMV ($250,000) OR Unpaid Debt ($300,000)
Greater of the above $300,000 Less Adjusted Basis $200,000 Capital Gains $100,000
Q 8. How is a deed in lieu of foreclosure treated for tax purposes?
A . A deed in lieu of foreclosure is treated as a sale and taxed just like a foreclosure.
See Questions 6 and 7 above.
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