Introduction

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 income can result from a foreclosure, deed in lieu of foreclosure, or short sale: capital gains, and relief of indebtedness income. Both types of income can trigger unexpected taxes for the owner.
 
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.

TAXATION OF FORECLOSURES OR DEEDS IN LIEU OF FORECLOSURE

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 are 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. Additionally, the owner can receive “forgiveness of debt” income. This will depend on whether the debt is “recourse” or “nonrecourse.” If the debt is recourse debt, the owner can receive income from the amount of debt that is forgiven by the lender. If the debt is nonrecourse debt, there is no taxable income from forgiveness of debt, but there may be still be income from capital gains.
 
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:

(1)  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
 
(2)  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.
 
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.
 
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 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 amount realized exceeds the amount of the adjusted basis, then the borrower has realized a gain at the time of the transfer (foreclosure).  If the adjusted basis exceeds the amount realized, then the borrower has a 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 income and it is treated as ordinary income.  This is treated as income despite the fact that the borrower has received no cash at the time of the foreclosure.

RECOURSE DEBT

Example One:

1. The unpaid principal of the loan is $300,000;

2. The fair market value of the property is $250,000;

3. The taxpayer’s adjusted basis in the property is $200,000.

Assume the lender forecloses and will forgive the underlying debt.
 
Step one:

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

Step two:

Amount of cancelled debt (amount owed on loan $300,000) 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.)

RECOURSE DEBT

Example Two:

If the amount realized 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 principal of the recourse debt is $300,000;

2. The fair market value of the property is $400,000;

3. The taxpayer’s adjusted basis in the property is $200,000.

Step one:

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

Step two:

The debt is fully paid (since the FMV exceeds the loan amount) resulting in no forgiveness of debt income.

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 the greater of the foreclosure proceeds or the entire outstanding debt and the adjusted basis of the property. This amount is treated as capital gains and there is no forgiveness of debt income

NONRECOURSE DEBT

Example:

1. The unpaid principal of the loan is $300,000;

2. The fair market value of the property is $250,000;

3. The taxpayer’s adjusted basis in the property is $200,000.

Greater of foreclosure proceeds (FMV $250,000) or entire outstanding debt ($300,000) minus taxpayer’s adjusted basis ($200,000) results in capital gains to the taxpayer.

Greater of
     FMV ($250,000)
OR  
    Outstanding 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.

TAXATION OF SHORT SALES

Q 9.  What are the tax implications of a short sale?

A  A short sale where the lender agrees to reduce some or all of the outstanding debt may give rise to forgiveness of debt income (also called “cancellation of debt” income).  The amount of the debt that the lender agrees to write off is treated as “ordinary income” (as opposed to capital gains income which is taxed at a lower rate).   Even though the lender may be taking this action to facilitate the sale by the owner who is under a notice of default and facing a foreclosure, the agreement between the owner and the lender is considered voluntary and treated as a debt reduction.  The taxpayer will generally receive a 1099 tax form from the lender in the amount of the debt reduction.

This “ordinary income” (from the forgiveness or cancellation of debt) under certain circumstances may or may not subject to taxation.  Under the Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648) signed by the President on December 20, 2007, Internal Revenue Code section 108(a)(1)(E) was added and provides that a taxpayer will not be taxed for cancellation of debt income if the following conditions are met:

• The property sold in the short sale is the taxpayer’s principal residence.
• The cancellation of debt is Qualified Principal Residence Indebtedness** under IRC Section 163(h)(3)(B).
• The indebtedness is discharged after January 1, 2007 and before January 1, 2010.

**Qualified Principal Residence Indebtedness is a loan secured by the residence used to acquire, construct or substantially improve the residence.  A refinance cannot exceed $1,000,000 in the case of a married person filing a separate return and $2,000,000 for all others.

Any reduction of indebtedness excluded by IRC Section 108(a)(1)(E) will be applied to reduce the basis of the taxpayer’s principal residence, but not below zero.

Finally, if the owner has owned the property for some time and has refinanced to take out some of the equity, the owner could be subject to capital gains taxation when selling the property as well.  For example, the borrower has a remaining loan on the property when the borrower refinances in order to buy other investment property (or to buy a car, or to take a vacation, etc.) and now owes $300,000 to the lender.  Thus, the taxpayer’s adjusted basis may be lower than the outstanding balance on the loan (as in the example below).

The tax calculation would look like step one in calculating a foreclosure sale of recourse debt.

SHORT SALE

Example:

1. The unpaid principal of the loan is $300,000;

2. The sales price (FMV) is $250,000;

3. The taxpayer’s adjusted basis in the property is $50,000.

Sales price (FMV $250,000) less taxpayer’s adjusted basis ($50,000) results in capital gains for the taxpayer.

Sales Price (FMV)           $250,000
Less  Adjusted Basis     $50,000
Capital Gains                  $200,000

Additionally, the taxpayer would have ordinary income from the lender’s write off of any debt, which in this example would be $50,000 (** See the discussion above in this question to determine whether or not this would be taxable)

 Loan Balance                $300,000
 Less Sales Price          $250,000
 Ordinary Income            $50,000

TAX EXEMPTIONS

Q 10.  Are there any exemptions from the relief of indebtedness income?

AYes. There are four other circumstances, in addition to what was dicussed in Question 9 on certain short sales, where the taxpayer can get relief from taxation on forgiveness of debt income:

(1) The taxpayer is insolvent (the taxpayer’s debts exceed their assets as determined under Bankruptcy Code Section 108(d)(3);

(2)  The debt is discharged as part of a bankruptcy proceeding;

(3)  The debt discharged is qualified farm indebtedness; or
 
(4)  The debt discharged is qualified business indebtedness (see 26 U.S.C. §108(c)).

Q 11.  Are there any exemptions from the capital gains taxation in a foreclosure, deed in lieu of foreclosure or short sale if the property is a principal residence?

A Yes. If the sale, whether through a foreclosure or deed in lieu or short sale, generates capital gains and if the property was the seller’s principal residence, the seller may be able to use the capital gains exclusion of $250,000 if single and $500,000 if filing a joint return. This exclusion does not apply to the ordinary income from debt relief.

MISCELLANEOUS

Q 12.  Which is better for an owner facing a distress sale: a foreclosure, a deed in lieu of foreclosure or a short sale?
 
A Any of these situations will impact the owner’s credit negatively. Additionally, the owner may have a significantly different tax liability depending on the disposition of the property. Consequently, this is a question that the owner needs to discuss with their own tax advisor.

Q 13.  What is a quick summary of these taxation rules?

Q 14.  Where can readers obtain more information on the subjects covered above?

A Information is available from a variety of sources, including:

• The Internal Revenue Service (IRS) (http://www.irs.gov/), which has detailed publications available for free on many tax related subjects.
• The IRS Tele-Tax system, which is an automated voice message information system with recorded information on many commonly asked tax questions.  Tele-Tax can be reached by calling 800.829.4477.
• A tax professional, such as a certified public accountant, tax attorney, or enrolled agent.

Copyright© 2008, CALIFORNIA ASSOCIATION OF REALTORS® (C.A.R.) Permission is granted to C.A.R. members only to reprint and use this material for non-commercial purposes provided credit is given to the C.A.R. Legal Department. Other reproduction or use is strictly prohibited without the express written permission of the C.A.R. Legal Department. All rights reserved

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Use the Map above to “Drive” around San Francisco with Google’s new street view feature. This is one of the coolest mapping tools I’ve seen. You can drive across the Bay Bridge, Golden Gate, or just about any street in town!

The view below is from the Bay Bridge looking at the city. Or turn the picture and you can look in the rear view mirror and see Treasure Island.

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Closings for some of the One Rincon Hill condos in the first tower are scheduled for February. I was just talking to a client who has a deposit down on one of the units. He is looking for an equity partner or perhaps a sale of his position. If anyone is interested in more information, please give me a call.

The Downtown San Francisco real estate market has remained robust despite the slowdown in many other markets in California and nationwide.  A market I have been following in addition to San Fran is the downtown San Diego highrise condo market.  With a supply surplus due to overbuilding, and a lack of qualified buyers, many properties have been discounted heavily to get buyers attention. 

Many REO’s (Bank owned properties) are available at good prices - some below prices as far back as 2002.  One condo that sold less than two years ago for 770k was just sold for 450k.  Another awesome deal was a 3000 sq ft highly upgraded condo with a direct view overlooking centerfield at Petco Park - home of the Padres and occaisional large venue concerts such as the Rolling Stones.  The new owner can sit on any of the three large balconies and watch the ballgame or show, the same as Wrigley field in Chicago.  The original owner paid 1.95MM for this home as a “shell” in 2003 and put an estimated 300k into the build out.  It was marketed for over 3.4MM at the peak of the market.  It just sold for 1,525,000 - a fantastic buy for a unique trophy property that will do well when the market rebounds.

One condo that just fell out of escrow and is currently available is a 1059 sq ft 2 bedroom at the El Cortez priced at 279,800 - a prime location in San Diego for well under $300 psf!

 If you’re interested in taking a closer look at some hot deals in San Diego, call Scott Osborne at 415-7334-8005.

As anticipated by the markets, the Fed has cut both the Fed Funds rate and the discount rate by .25% triggering a strong rally in the bond markets.  The 10 yr bond yield is back under 4% with a current yield of 3.96%.  

What does this mean?  Rates are continuing to fall making financing more attractive for both refinances and purchase financing.  For an instant rate quote for your specific scenario, please call Scott Osborne at 415-734-8005.  If you are buying at Infinity or One Rincon Hill and closing in February, or any other new development around town, please compare our rates to the in house lenders to see how much you can save!  Lowest rate guarenteed!

Press Release

Release Date: December 11, 2007

For immediate release

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 4-1/4 percent.

Incoming information suggests that economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending. Moreover, strains in financial markets have increased in recent weeks.  Today’s action, combined with the policy actions taken earlier, should help promote moderate growth over time.

Readings on core inflation have improved modestly this year, but elevated energy and commodity prices, among other factors, may put upward pressure on inflation.  In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

Recent developments, including the deterioration in financial market conditions, have increased the uncertainty surrounding the outlook for economic growth and inflation.  The Committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.

Voting for the FOMC monetary policy action were:  Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Charles L. Evans; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; William Poole; and Kevin M. Warsh.  Voting against was Eric S. Rosengren, who preferred to lower the target for the federal funds rate by 50 basis points at this meeting.

In a related action, the Board of Governors unanimously approved a 25-basis-point decrease in the discount rate to 4-3/4 percent.  In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, and St. Louis.

2007 Monetary Policy Releases

I recently highlighted the Walkscore for several of San Francisco’s new developments downtown.  Ritz Carlton Residences scored a perfect 100, both Millennium Tower and The Infinity scored 97, and One Rincon Hill scored a 91.  A new report out below reiterates the great walk-ability of many San Francisco neighborhoods:

Daily Real Estate News  |  December 4, 2007

Top 10 Most Walkable Cities
A Brookings Institution researcher says after the advent of the shopping mall, developers forgot how to build great cities, but that’s changing as urban areas again strive to be walkable.

“For 50 years we had this collective amnesia about how to build great places,” says Christopher B. Leinberger, a real estate developer and visiting fellow at Brookings.

Leinberger quantified the walk-ability trend by ranking the 30 largest metropolitan areas in terms of the number of walkable urban places they had clustered about them, then divided the number of places by the total population to find the cities with the most walking opportunities per capita.

Leinberger, who also teaches urban planning at the University of Michigan, counted 157 such “walkable places” — including Boston’s Beacon Hill, Miami’s Coconut Grove and the Houston area’s Sugar Land Town Square. The Tampa, Fla., area was the only one without a single place on his list.

Here are the top 10 cities with the most walkable places per capita, along with the number of most walkable areas:

• Washington-Arlington-Alexandria: 20 walkable places
• Boston-Cambridge-Quincy: 11
• San Francisco-Oakland-San Jose: 14
• Denver: 5
• Portland-Vancouver-Beaverton: 4
• Seattle-Tacoma-Bellevue: 6
• Chicago-Naperville-Joliet: 14
• Miami-Fort Lauderdale-Pompano Beach-Palm Beach: 4
• Pittsburgh: 3
• New York-Northern New Jersey-Long Island-Stanford, Conn.: 21

Source: The Associated Press, Sarah Karush (12/04/07)

December 03, 2007

Kick ‘em when they’re down

Unions representing hotel and textile workers have created a Web site advocating a boycott of Countrywide Financial Corp.’s banks and financial institutions. Countrywide’s not doing enough to help out troubled borrowers, the unions claim, so consumers shouldn’t let the lender use their savings to make more loans.

Contributing to Countrywide’s deposit base, the unions say, “will potentially help them issue more controversial loans. Tell Countrywide that you won’t deposit until it ensures that all subprime borrowers with interest rates that have reset in 2006 or 2007 can keep their homes!”

If Countrywide can be accused of kicking borrowers while they’re down, the same might be said of the boycott, depending on your point of view.

Countrywide shifted loan production over to its banking division, Countrywide Bank, in August after turmoil in credit markets made it impossible for it and other lenders to issue short term “commercial paper” debt. Countrywide was able to fund more than 90 percent of its mortgage loans through the bank in October, cutting subprime production to 0.2 percent.

Whatever your feelings about the UNITE HERE union boycott, it’s got to feel like a knife in the ribs to Countrywide executives, who have embarked on a do-or-die campaign to build the bank’s deposits. The campaign not only averted a run on the bank, but helped boost its assets by 28 percent from a year ago to $106 billion.

Of course, Countrywide’s got other, potentially more pressing problems, such as its $1.2 billion third quarter loss, class-action lawsuits by investors including large state pension funds, and allegations by the justice department that the company has been inflating claims against debtors in bankruptcy.

 From a post by Matt Carter at Inman news

Top Scores for Residential buildings downtown:

100 Ritz Carlton Residences
98 SF Blu
97 Millennium Tower San Francisco
95 Infinity Tower
91 One Rincon Hill
91 Metropolitan
89 The Brannan
89 Park Terrace
80 The Radiance Mission Bay
80 Arterra

Walkable communities tend to have the following characteristics:

A center:Walkable neighborhoods have a discernible center, whether it’s a shopping district, a main street, or a public space.
Density: The neighborhood is dense enough for local businesses to flourish and for public transportation to be cost effective.
Mixed income, mixed use: Housing is provided for everyone who works in the neighborhood: young and old, singles and families, rich and poor. Businesses and residences are located near each other.
Parks and public space: There are plenty of public places to gather and play.
Accessibility: The neighborhood is accessible to everyone and has wheelchair access, plenty of benches with shade, sidewalks on all streets, etc.
Well connected, speed controlled streets: Streets form a connected grid that improves traffic by providing many routes to any destination. Streets are narrow to control speed, and shaded by trees to protect pedestrians.
Pedestrian-centric design: Buildings are placed close to the street to cater to foot traffic, with parking lots relegated to the back.
Close schools and workplaces: Schools and workplaces are close enough that most residents can walk from their homes.
Information compiled from CoolTown Studios and Walkable Communities, Inc.