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The Ins and Outs of Short Sales

From the California Association of Realtors Magazine-

Agents handling short sales are aware that short sale transactions have a number of legal issues that may arise. As attorneys on the C.A.R. legal hotline, we have received a number of questions on deficiency judgments and tax issues in short sales. Here are some of the queries we are commonly asked, and a summary of the information we provide to our members.

Can Lenders Recover the Deficiency?

In a short sale, a lender agrees to allow the sale of the seller’s property even though the lender will not be receiving the full amount the seller owes from the proceeds of the sale. The difference between the proceeds from the sale and the amount owed is a defi ciency. The question naturally arises as to whether the lender can try to recover that deficiency from the seller.

Prior to Jan. 1, 2011, the only way to be sure that the lender would not be able to recover a defi ciency from a seller was to have clear language in the short sale agreement between the lender and the borrower that the lender would waive any right to pursue obtaining the defi ciency amount from the seller. If there was not any language waiving the right to pursue a deficiency against the seller, the lender would likely be able to pursue the seller for the deficiency.

However, in January of this year, Civil Code section 580e was added to California law, which states that when the first trust deed holder gives written consent to a short sale on a residential one- to four-unit property—investment or owner occupied—the lender is no longer able to obtain a deficiency judgment against the seller. So now even if the first lender does not explicitly waive its defi ciency right in its short sale agreement with the seller, the lender will be unable to get a deficiency judgment.

The new law does not, however, pertain to second trust deed holders. Even if they approve a short sale, in the absence of clear language in the short sale agreement that the second will not pursue a deficiency judgment, the second trust deed holder may be able to pursue the seller for the deficiency amount.

If the second lender does not waive the deficiency, and the short sale goes through, the second lender would still need to sue the seller and obtain the deficiency judgment in court in order to place liens on any of the seller’s property or garnish his or her wages.

Finally, while the new law does offer protection to the borrower, it would still be a good practice to have the lender clearly release its right to pursue the deficiency amount from the seller in the short sale agreement.

Can Forgiven Debt Be Taxed?

Short sales raise a number of complex tax issues for sellers. In a short sale in which the lender agrees to cancel or “forgive” all or a certain portion of the debt that is owed, the IRS and FTB may treat that cancellation of debt as income for the seller. This income is taxed at the person’s tax rate for ordinary income. As you can imagine, that could lead to severe tax consequences for persons involved in a short sale, especially in an area with substantial price declines. 

However, many short sellers, fortunately, are not likely to have any—or at least a much lower—tax liability from the cancellation of debt. This is due to laws passed both on the federal level and in California that offer tax relief for cancellation of debt income in short sales and also due to the insolvency provision of the tax laws.

Under the federal Mortgage Debt Relief Act of 2007, a seller involved in a short sale could see a significant reduction in or even pay no tax on his or her canceled debt. If the property involved in the short sale is the taxpayer’s principal residence and the mortgage on the property was taken out to acquire, construct, or substantially improve the residence, then the canceled debt will not be subject to taxation. A refinance of the property may still be exempt from debt relief income tax, but if any cash was taken out in addition to the original mortgage, that cash will only be exempt to the extent it was used to substantially improve the property. So, for example, if a seller refinanced but took out $100,000 to pay off credit cards and buy a new car, that portion of the debt would remain taxable. The cancellation of debt income exemption is capped at $2,000,000 or $1,000,000 for a married person fi ling separately.

California law mirrors the federal law but has lower limits for the amount of cancellation of debt income that is exempt: either $500,000 for most persons or $250,000 for a married person or person in a registered domestic partnership filing separately. Also there is a cap on the overall amount of indebtedness eligible for tax relief under California law of $800,000 for most persons and $400,000 for a married person filing separately.

Both laws are scheduled to terminate at the end of 2012.

Can Insolvency Lead to Tax Relief?

Even if a seller of property is not eligible or only partly eligible for relief under the federal and state cancellation of debt income laws, it is possible she or he could get relief for being “insolvent” under the tax laws. If, at the time the debt is canceled by the lender, the seller’s liabilities are greater than the seller’s assets, he or she is “insolvent” under the tax laws. The amount of tax due for the cancellation of debt could be significantly reduced or eliminated depending on the amount that the liabilities exceed the assets.

One benefit of the insolvency provision of the tax code for sellers is that it applies to situations not covered by the state and federal cancellation of debt income laws described above. Tax relief available due to insolvency applies regardless of what type of property is involved in the short sale. For example, it could apply to a residential investment property or a second home as well as someone’s primary residence. It also applies to someone who refinanced a property and took signifi cant cash out for reasons other than home improvements and therefore perhaps would not get as much relief under the 2007 Mortgage Debt Relief Act.

In order for a seller to ascertain whether he or she qualifies as insolvent and, if so, how much relief that will provide, the seller should be advised to seek the advice of a tax professional. However, the IRS does offer a worksheet that can assist a seller in calculating the extent that he or she is insolvent.

Will Canceled Debt Be 1099-ed?

A common question from REALTORS® on the hotline concerns whether the client will get a 1099 for the canceled debt. Some sellers have misunderstood the new cancellation of debt income laws and believe they will not get a 1099 or will get a 1099 only for those amounts not covered by the debt relief laws. This is incorrect. The seller will almost always receive a 1099 when there is canceled debt. While the canceled debt may not be taxable, it still needs to be reported. Generally, the seller will not receive a 1099 only when the 

lender is not canceling the debt. For example, a second trust deed holder may agree to a short sale but will not agree to waive its right to pursue a deficiency judgment against a seller and therefore will not issue a 1099 because no debt has been canceled.

A solid understanding of the tax and defi ciency issues in short sales are important for you as a REALTOR® to understand. However, a warning that when it comes to your own client’s specific situation—for example, if a client asks you to figure out exactly how much tax he or she will owe—advise him or her to seek advice from an appropriate professional. REALTORS® should not provide legal or tax advice. 

Sanjay Wagle, Esq., is an attorney at C.A.

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