It’s the forces that follow foreclosure.
The junior lender and the tax man can deliver truly punishing blows to a family losing a home.
Cut-off Junior Lienholders
Californians enjoy the protection of the one action rule governing foreclosures.
A creditor who conducts a non judicial foreclosure of its security interest cannot collect anything more than the property it forecloses on.
Foreclosure is, as lawyers say, an election of remedies. When the lender chooses to foreclose, it gives up the right to pursue the borrower for anything more.
But, the typical foreclosure sale destroys all liens on the property that are junior (inferior) to the foreclosing creditor.
The HELOC lender, the second deed of trust, the SBA loan are rendered unsecured by the sale. Even though they no longer have a lien on the foreclosed property, those cut off lienholders CAN sue you for what’s owed on the debt.
The exception is the California purchase money rule:
If the junior lien secured a loan used to acquire a property you used as your home when you bought it, the lender cannot pursue you personally. The limitation on purchase money lenders suing you personally is often called the “antideficiency” statute.
So, if foreclosure is in the cards, you need to have a plan for dealing with the other players who no longer have a lien on the real property. There’s a four year statute of limitations on collection actions, so the problem doesn’t go away quickly.
Cancellation of Debt Income
The tax code provides the second blow in these unhappy circumstances: debt that is forgiven may be treated as if it were cash received by the borrower whose debt is satisfied for less than was owed.
In an era of falling home prices, homeowners more often receive a 1099 following the foreclosure sale that reports the difference between the fair market value of the property foreclosed and the amount of the debt owed to the foreclosing creditor.
Unless you fall into one of the exceptions found on IRS Form 982, the difference between those two numbers is reported as income on your tax return.
Up to 2014, there was a temporary safe harbor from federal income tax through 2014 if the property foreclosed was the owner’s principal residence to the extent the loan was used to buy the property. Relief under state law varies.
That fix has expired and whether it is reinacted is impossible to say.
Bankruptcy changes the rules
You can turn both of these ugly rules on their heads if you file bankruptcy before any foreclosure.
A bankruptcy filing before a foreclosure sale eliminates both your personal liability to the junior lien holders and the possibility of tax liability on forgiven debt.
Tax law provides that debts forgiven in bankruptcy don’t generate cancellation of debt income. That applies to both forgiveness of debt to the foreclosing creditor and liability to the cut off junior lien holders.
If you’ve filed bankruptcy, the tax protection that bankruptcy generates lasts. So long as the debt was forgiven in the bankruptcy, a foreclosure down the road by those who then hold the forgiven debts has no tax consequences.
It’s worth noting that a short sale may expose the homeowner to cancellation of debt income, too.
California law now requires that lien holders who consent to a short sale waive their rights to sue….so forgiveness of the debt is mandated.
Facing foreclosure is a stressful time, but it pays to look at the possibilities for collateral damage before you resign yourself to going through foreclosure.