Michelle Theisen, Pre-Foreclosure Specialist

For almost a decade now, every time we talked about real estate we immediately discussed money. We didn't talk about the value of a home but instead about the price of the house. We didn't worry about a roof over our heads but instead the ceiling on our interest rate. We didn't care as much about where we raised our family as we cared about how much we increased our family's net worth.

That will change in 2011. We believe very strongly that real estate will return to what it has been for the 200+ year history of this country: a place for us and our families to live comfortably. It will also prove to be a great long term investment as it always has been.

Our parents and our grandparents didn't buy their homes as a short term financial investment. They bought it so they had a place of their own to come home to at the end of the day; a place to raise their family; a place they could feel safe.

Sure they dreamed of a ‘mortgage-burning' party. They realized it was a form of forced savings. They were taught that, if they paid their mortgage every month, they would wind up with a little retirement account decades later.

And, they realized that wouldn't happen if they rented.

However, in the last decade, we somehow forgot that the financial aspect was the serendipity not the major reason to buy. We believe that 2011 will be the year that people return to the historic reasons families purchased a home. This is the year when we again remember that homeownership is a major part of the American Dream.

What about the challenges to a housing recovery? Let's look at them.

The Economy

Most reports are showing that the economy is doing better than expected. This shopping season provided additional proof of this point. As the economy recovers, so will consumer confidence. This will be great news for housing.

Unemployment

There is much talk about a ‘jobless recovery'. We agree that unemployment will continue to be a challenge. However, when you talk about housing, it is not the unemployment rate that is all telling. Instead, it is the change in the rate. As unemployment skyrocketed, people started to worry about their own job. Any change creates concern. Unabated concern turns to fear. Fear causes paralysis. The spike in unemployment has plateaued. People no longer have the feeling that ‘they are next'. The fear will diminish and people will start moving on with their lives. This too will be great news for housing.

Interest Rates

It seems the bottomless pit in which rates have been falling does have a floor after all. And it seems we have found it. Those purchasers who had been waiting for the best interest rate may have already missed it.

Prices

Economists are projecting that prices will not see any appreciation in 2011. Sellers who had been waiting for 2006 to return will come to the realization that waiting any longer makes little sense. They will instead decide to get on with their lives and sell this year.

Prices probably will soften further. However, the possible savings to potential buyers will be minimized by a rise in interest rates.

Bottom Line

This is the year that normalcy returns to real estate. People will buy and sell based on the desire for a better life for themselves and their families. They will realize that is the true value of homeownership and they will be willing to pay for that value.

(Written by Steve Harney, a national speaker on real estate issues)

One of the concerns a consumer has after experiencing a bankruptcy, foreclosure, or short sale (referred to as a "preforeclosure sale" by Fannie Mae when the owner is in default) is the ability to obtain credit to purchase another home. Fannie Mae has updated its credit guidelines in the FNMA Selling Guide, June 30, 2010. [ Note: This is a 1,234 page PDF document that takes a long time to download.] This legal article summarizes those guidelines in Part I. In addition, since lenders use FICO scores in order to determine the creditworthiness of a borrower, this article covers the impact of a bankruptcy, foreclosure or short sale on FICO scores in Part II.

I. Fannie Mae Credit Guidelines

A. Credit after Foreclosure

Q 1. How long is the time period after a foreclosure before a consumer can be eligible to obtain credit to purchase a home?

A Seven years from the date the foreclosure sale was completed as reported on the credit report or other foreclosure documents provided by the borrower. See Question 2 below for exceptions.

(Source: FNMA Selling Guide, 6-30-10 at 426 )

Q 2. Does a shorter time period apply if the borrower has "extenuating circumstances" that led to the foreclosure?

A Yes. The borrower may again be eligible for a loan three years from the date the foreclosure sale was completed if the borrower has "extenutating circumstances" as defined in Question 3.

Additional requirements that apply after 3 years and up to 7 years following the completion date are as follows:

• The purchase must be of a principal residence. Purchase of a second home or investment property is not permitted until the seven-year waiting period has elapsed.
  
• The consumer is limited to a maximum loan to value ratio of 90 percent. If the Eligibility Matrix(https://www.efanniemae.com/sf/refmaterials/eligibility/pdf/eligibilitymatrix.pdf ) sets forth a lower maximum loan-to-value ratio for the transaction at hand, then the consumer is limited to the lower maximum loan-to-value ratio.
  
• Limited cash-out refinances are permitted for all occupancy types. (Cash-out refinances are not permitted until a seven-year waiting period has elapsed.)

(Source: FNMA Selling Guide, 6-30-10 at 426-7 .)

Q 3. What are"extenuating circumstances"?

A Fannie Mae describes "extenuating circumstances" as follows:

Extenuating circumstances are nonrecurring events that are beyond the borrower's control that result in a sudden, significant, and prolonged reduction in income or a catastrophic increase in financial obligations.

If a borrower claims that derogatory information is the result of extenuating circumstances, the lender must substantiate the borrower's claim. Examples of documentation that can be used to support extenuating circumstances include documents that confirm the event (such as a copy of a divorce decree, medical bills, notice of job layoff, job severance papers, etc.) and documents that illustrate factors that contributed to the borrower's inability to resolve the problems that resulted from the event (such as a copy of insurance papers or claim settlements, listing agreements, lease agreements, tax returns (e.g., covering the periods prior to, during, and after a loss of employment).

The lender must obtain a letter from the borrower explaining the relevance of the documentation. The letter must support the claims of extenuating circumstances, confirm the nature of the event that led to the bankruptcy or foreclosure-related action, and illustrate the borrower had no reasonable options other than to default on his or her financial obligations.

(Source: FNMA Selling Guide, 6-30-10, 6-30-10 at 429 .)

Q 4. What are the requirements to re-establish a credit history after a foreclosure?

A After a foreclosure, a credit history must meet the following requirements to be considered re-established:

• The elapsed time and the related requirements are met (as discussed in this article).

• The loan receives a recommendation from Desktop Underwriter (an automated underwriting system) that is acceptable for delivery to Fannie Mae. If manually underwritten, then the loan must meet the minimum credit score requirements based on the parameters of the loan and the established eligibility requirements.

• The borrower has traditional credit as outlined in the Selling Guide, B3-5.3, Traditional Credit History (https://www.efanniemae.com/sf/guides/ssg/sg/pdf/sel043010.pdf). Nontraditional credit or “thin files” are not acceptable. A “thin file” exists where the borrower does not have a sufficient number of credit references to develop a traditional credit report.

(Source: FNMA Selling Guide, 6-30-10, 6-30-10 at 428).

B. Credit after Deed-in-Lieu (DIL) of Foreclosure

Q 5. How long is the time period after a deed-in-lieu of foreclosure before a consumer can be eligible to obtain credit to purchase a property?

A After two years from the date the deed in lieu was executed, but the consumer is limited to a maximum loan-to-value ratio of 80 percent. If the Eligibility Matrix (https://www.efanniemae.com/sf/refmaterials/eligibility/pdf/eligibilitymatrix.pdf) sets forth a lower maximum loan-to-value ratio for the transaction at hand, then the consumer is limited to the lower maximum loan-to-value ratio.

After four years, the consumer is limited to a maximum loan to value ratio of 90 percent. If the Eligibility Matrix (https://www.efanniemae.com/sf/refmaterials/eligibility/pdf/eligibilitymatrix.pdf) sets forth a lower maximum loan-to-value ratio for the transaction at hand, then the consumer is limited to the lower maximum loan-to-value ratio.

After seven years, the consumer is limited to the loan-to-value ratios set forth in the Eligibility Matrix. (https://www.efanniemae.com/sf/refmaterials/eligibility/pdf/eligibilitymatrix.pdf)

(Source: FNMA Selling Guide, 6-30-10, 6-30-10 at 427.)

Q 6. Does a shorter time period apply if the borrower has "extenuating circumstances" that led to the deed-in-lieu of foreclosure?

A Yes. Two years from the date the deed-in-lieu was executed, but the consumer is limited to a maximum loan-to-value ratio of 90 percent. If the Eligibility Matrix (https://www.efanniemae.com/sf/refmaterials/eligibility/pdf/eligibilitymatrix.pdf) sets forth a lower maximum loan-to-value ratio for the transaction at hand, then the consumer is limited to the lower maximum loan-to-value ratio.

(Source: FNMA Selling Guide, 6-30-10, 6-30-10 at 427.)

See Question 3 for the definition of "extenuating circumstances."

Q 7. Are deed-in-lieu of foreclosure actions identified on a credit report?

A A deed-in-lieu of foreclosure may be reported by a remarks code indicating a deed-in-lieu.

(Source: FNMA Announcement 08-16 Q&A, 8-13-08. )

Q 8. What are the requirements to re-establish a credit history after a deed-in-lieu of foreclosure?

A After a deed-in-lieu of foreclosure, a credit history must meet the following requirements to be considered re-established:

• The elapsed time and the related requirements are met (as discussed in this article).

• The loan receives a recommendation from Desktop Underwriter (an automated underwriting system) that is acceptable for delivery to Fannie Mae. If manually underwritten, then the loan must meet the minimum credit score requirements based on the parameters of the loan and the established eligibility requirements.

• The borrower has traditional credit as outlined in the Selling Guide, B3-5.3, Traditional Credit History (https://www.efanniemae.com/sf/guides/ssg/sg/pdf/sel043010.pdf). Nontraditional credit or “thin files” are not acceptable. A “thin file” exists where the borrower does not have a sufficient number of credit references to develop a traditional credit report.

(Source: FNMA Selling Guide, 6-30-10 at 428).

C. Credit after a Short Sale (Preforeclosure Sale)

Q 9. How long is the time period after a " preforeclosure sale" before a consumer can be eligible to obtain credit to purchase a property?

A After two years from the date the preforeclosure sale was completed, but the consumer is limited to a maximum loan-to-value ratio of 80 percent. If the Eligibility Matrix(https://www.efanniemae.com/sf/refmaterials/eligibility/pdf/eligibilitymatrix.pdf) sets forth a lower maximum loan-to-value ratio for the transaction at hand, then the consumer is limited to the lower maximum loan-to-value ratio.

After four years, the consumer is limited to a maximum loan to value ratio of 90 percent. If theEligibility Matrix (https://www.efanniemae.com/sf/refmaterials/eligibility/pdf/eligibilitymatrix.pdf) sets forth a lower maximum loan-to-value ratio for the transaction at hand, then the consumer is limited to the lower maximum loan-to-value ratio.

After seven years, the consumer is limited to the loan-to-value ratios set forth in the Eligibility Matrix(https://www.efanniemae.com/sf/refmaterials/eligibility/pdf/eligibilitymatrix.pdf).

(Source: FNMA Selling Guide, 6-30-10, 6-30-10 at 427.)

Q 10. What is a "preforeclosure sale" mentioned in Question 9 and is that the same as a short sale?

A "A preforeclosure sale involves the sale of the property by the borrower to a third party for less than the amount owed to satify the delinquent mortgage, as agreed to by the lender, investor, and mortgage insurer"

Although the terms preforeclosure sale and short sale have been used interchangeably, there is a significant difference for purposes of obtaining credit. For Fannie Mae purposes, a preforeclosure assumes that the borrower has been delinquent in paying his or her mortgage and the lender agrees to accept a lesser amount to avoid the time and expense of a foreclousre action. A short-sale, however, can also refer to situations in which the lender of the mortgage agrees to a payoff of a lesser amount than is actually owed, even on a current mortgage, to facilitate the sale of the property to a third party.

(Source: FNMA Announcement 08-16 Q&A, 8-13-08. )

Q 11. Does a shorter time period apply if the borrower has "extenuating circumstances" that led to the preforeclosure (short) sale?

A Yes. Two years from the date the preforeclosure sale was completed, but the consumer is limited to a maximum loan-to-value ratio of 90 percent. If the Eligibility Matrix(https://www.efanniemae.com/sf/refmaterials/eligibility/pdf/eligibilitymatrix.pdf) sets forth a lower maximum loan-to-value ratio for the transaction at hand, then the consumer is limited to the lower maximum loan-to-value ratio.

(Source: FNMA Selling Guide, 6-30-10 at 427 .)

Q 12. If a borrower sold his or her property as a short sale but was never delinquent on that mortgage and is now attempting to purchase a new primary residence, will Fannie Mae purchase the loan?

A The loan will be eligible for delivery to Fannie Mae provided that the borrower's previous mortgage history complies with Fannie Mae's excessive prior mortgage delinquency policy--that is the borrower does not have one or more 60-, 90-, 120-, or 150-day delinquencies reported within the 12 months prior to the credit report date--and the borrower has not entered into any agreement with the short sale lender to repay any amounts associated with the short sale, including a deficiency judgment.

(Source: FNMA Announcement 08-16 Q&A, 8-13-08 ; FNMA Selling Guide, Part X, Chapter 3, Section 302.09. .)

Q 13. Are preforeclosure sales (short sales) identified on a credit report?

A Preforeclosure sales may be reported as "paid in full" with a "settled for less than owed" remarks code, and the mortgage tradeline would indicate any recent delinquency.

(Source: FNMA Announcement 08-16 Q&A, 8-13-08. )

D. Credit after a Bankruptcy

Q 14. How long is the time period after a Chapter 7 or Chapter 11 bankruptcy before a consumer can be eligible to obtain credit to purchase a property?

A Four years from the discharge or dismissal date of the bankruptcy action.

(Source: FNMA Selling Guide, 6-30-10 at 425 .)

Q 15. How long is the time period after a Chapter 13 bankruptcy before a consumer can be eligible to obtain credit to purchase a property?

A Two years from the discharge date and four years from the dismissal date. The shorter waiting period based on the discharge date recognizes that borrowers have already met a portion of the waiting period within the time needed for the successful completion of a Chapter 13 plan and subsequent discharge.

(Source: FNMA Selling Guide, 6-30-10 at 425 .)

Q 16. Does a shorter time period apply if the borrower has "extenuating circumstances" that led to the bankruptcy (all actions)?

A Yes. Two years from the discharge or dismissal; however, no exceptions are permitted to the 2-year time period after a Chapter 13 discharge.

(Source: FNMA Selling Guide, 6-30-10 at 425-6 .)

See Question 3 for the definition of "extenuating circumstances."

Q 17. How long is the time period after multiple bankruptcy filings before a consumer can be eligible to obtain credit to purchase a property?

A Five years from the most recent dismissal or discharge date for borrowers with more than one bankruptcy filing within the past 7 years.

(Source: FNMA Selling Guide, 6-30-10 at 426 .)

Q 18. What are “multiple bankruptcy filings”?

A This means an individual borrower has filed for bankruptcy more than one time. Two or more borrowers with individual bankruptcies are not cumulative, and do not constitute multiple bankruptcies. For example, if the borrower has one bankruptcy and the co-borrower has one bankruptcy, this is not considered a multiple bankruptcy.

(Source: FNMA Selling Guide, 6-30-10 at 426 .)

Q 19. Does a shorter time period apply if the borrower has "extenuating circumstances" that led to the multiple bankruptcies?

A Yes. Three years from the most recent discharge or dismissal date. The most recent bankruptcy filing must have been the result of extenuating circumstances.

(Source: FNMA Selling Guide, 6-30-10 at 426 .)

See Question 3 for the definition of "extenuating circumstances."

Q 20. What is the difference between a Chapter 13 bankruptcy and a Chapter 7 bankruptcy?

A Chapter 13 permits a borrower with a regular income to propose a plan to repay some or all of his or her obligations over a period of up to five years. A borrower who files a Chapter 7 is permitted to retain exempt assets and receive a discharge of the borrower's debts. Chapter 7 is a relatively quick liquidation process that is generally completed within 120 days. Chapter 7 cases are rarely dismissed.

(Source: FNMA Announcement 08-16 Q&A, 8-13-08. )

Q 21. What is the difference between a Chapter 13 dismissal and a Chapter 13 discharge?

A A borrower who files a Chapter 13 can dismiss the case at any time (voluntary dismissal) or the case may be dismissed by the court based on the borrower's failure to comply with the requirements of the Bankruptcy Code or to make the required payments. If the borrower who files a Chapter 13 case makes all of the payments required by the plan, the borrower receives a discharge at the end of the plan. A borrower who doesn't make all the payment required by the plan may still receive a discharge if the court finds, among other things, that the borrower made a certain amount of the payments and the borrower's failure to make all of the payments was due to circumstances beyond the borrower's control.

(Source: FNMA Announcement 08-16 Q&A, 8-13-08. )

Q 22. What are the requirements to re-establish a credit history?

A After a bankruptcy, a credit history must meet the following requirements to be considered re-established:

• The elapsed time and the related requirements are met (as discussed in this article).

• The loan receives a recommendation from Desktop Underwriter (an automated underwriting system) that is acceptable for delivery to Fannie Mae. If manually underwritten, then the loan must meet the minimum credit score requirements based on the parameters of the loan and the established eligibility requirements.

• The borrower has traditional credit as outlined in the Selling Guide, B3-5.3, Traditional Credit History (https://www.efanniemae.com/sf/guides/ssg/sg/pdf/sel043010.pdf). Nontraditional credit or “thin files” are not acceptable. A “thin file” exists where the borrower does not have a sufficient number of credit references to develop a traditional credit report.

(Source: FNMA Selling Guide, 6-30-10 at 428).

II. Bankruptcy, Foreclosure, and Short Sale and the Impact on a FICO ®Score

Q 23. What is a FICO® Score?

A A FICO® score is a number representing the creditworthiness of a person or the likelihood that person will pay his or her debts. The three credit reporting agencies, Equifax, Experian, and TransUnion, collect data about consumers in order to compile credit reports. The credit agencies use FICO® software to generate FICO® scores, which are then sold to lenders. Actually FICO® is just one of the several credit scoring systems available. The Fair Isaac Corporation (known as FICO®) created the first credit scoring system in 1958. Others are NextGen, VantageScore, and the CE Score. They all evaluate the creditworthiness of a borrower. However, FICO appears to be the most-used credit scoring system. A FICO® score is between 300 and 850. The higher the better the credit.

Each consumer has three credit scores at any given time for any given scoring model because the three credit agencies have their own databases, gather reports from different creditors, and receive information from creditors at different times.

Q 24. What factors go into determining a FICO® score?

A Credit scores are designed to measure the risk of default by taking into account various factors in a person's financial history. Although the exact formulas for calculating credit scores are closely-guarded secrets, FICO® has disclosed the following components and the approximate weighted contribution of each:

35% — Payment History – Late payments on bills, such as a mortgage, credit card or automobile loan, can cause a consumer’s FICO® score to drop. Paying bills as agreed over time will improve a consumer’s FICO® score.

30% — Credit Utilization - The ratio of current revolving debt (such as credit card balances) to the total available revolving credit (credit limits). Consumers can improve their FICO® scores by paying off debt and lowering their utilization ratio. The closing of existing revolving accounts will typically adversely affect this ratio and therefore have a negative impact on the FICO® score.

15% — Length of Credit History – As a consumer's credit history ages, assuming the consumer pays his or her bills, it can have a positive impact on the FICO® score.

10% — Types of Credit Used (installment, revolving, consumer finance) – Consumers can benefit by having a history of managing different types of credit.

10% — Recent search for credit and/or amount of credit obtained recently - Multiple credit inquiries for a consumer seeking to open new credit, such as credit cards, retail store accounts, and personal loans, can hurt an individual’s score. Applying for lots of new credit in a short period of time is also viewed as risky and can cause a drop in an individual’s score. However, individuals shopping for a mortgage or auto loan over a short period will likely not experience a decrease in their scores as a result of these types of inquiries.

(Source: http://www.myfico.com/CreditEducation/WhatsInYourScore.aspx)

Q 25. How does a mortgage modification affect my FICO® score?

A FICO® credit scores are calculated from the information in consumer credit reports. Whether a loan modification affects the borrower's FICO® score depends on whether and how the lender chooses to report the event to the credit bureau, as well as on the person's overall credit profile. If a lender indicates to a credit bureau that the consumer has not made payments on a mortgage as originally agreed, that information on the consumer's credit report could cause the consumer's FICO® score to decrease or it could have little to no impact on the score.

(Source: http://www.myfico.com/crediteducation/questions/Mortgage_Modification.aspx)

Q 26. How does a bankruptcy affect my FICO® score?

A A bankruptcy is considered a very negative event regardless of the type. A bankruptcy is factored into your FICO® score until it is removed from your credit report. As long as the bankruptcy is listed on your credit report, it will be factored into your score. If you are considering bankruptcy as an alternative to foreclosure, keep in mind that it may have a greater impact on your FICO® score.

Typically, you can expect bankruptcies to impact your FICO® score, from the date filed, as follows:

(1) Chapter 11 and Chapter 7 bankruptcies up to 10 years.

(2) Completed Chapter 13 bankruptcies up to 7 years.

These time periods refer to the public record item associated with filing for bankruptcy. All of the individual accounts included in the bankruptcy should be removed from your credit report after 7 years.

(Source: http://www.myfico.com/crediteducation/Questions/Bankruptcy-Types.aspx)

If you plan to file a bankruptcy, here are some things you should do to make sure your creditors are accurately reporting the bankruptcy filing:

(1) Check your credit report to ensure that accounts that were not part of the bankruptcy filing are not being reported with a bankruptcy status.

(2) Make sure your bankruptcy is removed as soon as it is eligible to be "purged" from your credit report.

After a bankruptcy has been filed, the sooner you begin re-establishing credit in good standing, the sooner you can expect your FICO® score to rebound. A good practice is to obtain a secured credit card and continually make all of your payments on time. As time passes and the impact of the bankruptcy lessens, you might apply for a traditional credit card and also continually make all of your payments on time.

(Source: http://www.myfico.com/crediteducation/questions/Bankruptcy-Reach.aspx)

Q 27. How does a short sale, deed-in-lieu-of foreclosure. or a foreclosure affect my FICO®score?

A The alternatives to foreclosure, such as a deed-in-lieu of foreclosure or a short sale, aren’t any better as far as a FICO® score is concerned.

The common alternatives to foreclosure, such as short sales, and deeds-in-lieu of foreclosure are all "not paid as agreed" accounts, and considered the same by your FICO® score. This is not to say that these may not be better options for you from a financial or tax perspective, just that they will be considered no better or worse for your FICO® score.

If you are considering bankruptcy as an alternative to foreclosure, that may have a greater impact on your FICO® score. While a foreclosure is a single account that you default on, declaring bankruptcy has the opportunity to affect multiple accounts and therefore has potential to have a greater negative impact on your FICO® score.

(Source: http://www.myfico.com/CreditEducation/Questions/foreclosure-alternatives-fico-score.aspx)

Q 28. What won't affect my FICO® score?

A The following information is not considered by the FICO® scoring formula:

^. Your race, color, religion, national origin, sex, or marital status

^. Your age

^. Your salary, occupation, title, employer, date employed, or employment history

^. Where you live

^. Any interest rate being charged on a particular credit card or other account

^. Certain types of inquiries (such as promotional, account review, insurance or employment-related inquiries)

^. Credit counseling

^. Any information not found in your credit report

^. Any information that is not proven to be predictive of future credit performance

(Source: http://myfico.custhelp.com/cgi-bin/myfico.cfg/php/enduser/std_adp.php?p_faqid=55)

Q 29. Where can I get more information?

A For a credit missteps comparison (i.e., affect on credit scores after certain events), go tohttp://www.myfico.com/crediteducation/questions/Credit_Problem_Comparison.aspx.

This legal article is just one of the many legal publications and services offered by C.A.R. to its members. For a complete listing of C.A.R.'s legal products and services, please visit car.org.

Readers who require specific advice should consult an attorney. C.A.R. members requiring legal assistance may contact C.A.R.'s Member Legal Hotline at (213) 739-8282, Monday through Friday, 9 a.m. to 6 p.m. and Saturday, 10 a.m. to 2 p.m. C.A.R. members who are broker-owners, office managers, or Designated REALTORS® may contact the Member Legal Hotline at (213) 739-8350 to receive expedited service. Members may also submit online requests to speak with an attorney on the Member Legal Hotline by going to http://www.car.org/legal/legal-hotline-access/. Written correspondence should be addressed to:

CALIFORNIA ASSOCIATION OF REALTORS®
Member Legal Services
525 South Virgil Avenue
Los Angeles, CA 90020

Introduction

The real estate industry, on a large-scale basis, has been flooded with foreclosures, deeds- in-lieu of foreclosure, and short sales of real property. These distress sales and foreclosures are the result of a convergence of tightening credit, falling property values, and the consequences of prior lending practices.

Adding insult to injury, owners of real property facing these circumstances, 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 income ( also known as cancellation of debt—COD income). COD income has also been referred to as “phantom 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, in 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. This article has been updated to reflect the recent California Mortgage Debt Forgiveness Tax law signed by the governor on April 12, 2010 as part of the California Conformity Act of 2010.

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

Q2. 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's 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" (COD) income. Whether the owner is subject to taxation on COD 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.

Q4. 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 should the property be worth less than the loan amount.

Q5. 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.

Q6. 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(federal law) and SB 401 (the Conformity Act of 2010—California law), there will be no taxation on this forgiveness of debt (COD income). See Question 9 for a definition of "qualified principal residence indebtedness."

RECOURSE DEBT

Example One:

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.

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 $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.

RECOURSE DEBT

Example Two:

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.

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 of $400,000 exceeds the unpaid loan amount of $300,000) resulting in no forgiveness of debt.

Q7. 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.)

NONRECOURSE DEBT

Example:

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

Q8. 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

Q9. What are the tax implications of a short sale?

A

Cancellation of Debt (COD) Income

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" or COD 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 the amount of the loan written off by the lender is treated as forgiveness of debt (cancellation of debt--COD). The taxpayer will generally receive a 1099 tax form from the lender in the amount of the cancellation of debt.

This forgiveness or cancellation of debt which is treated as "ordinary income" under certain circumstances may or may not be subject to taxation.

Federal Mortgage Forgiveness Debt Relief

Under the Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648) signed by the President on December 20, 2007, Internal Revenue Code §108(a)(1)(E) was added and provides that a taxpayer will not be taxed upon cancellation of debt income if the following conditions are met:

^. The property sold in the short sale is the taxpayer's principal residence, as that term is used in IRC §121.
^. 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, 2013. (The end date was increased by three years from 2010 to 2013 pursuant to H.R. 1424, the Emergency Economic Stabilization Act of 2008).

**Qualified Principal Residence Indebtedness is a loan secured by the residence used to acquire, construct or substantially improve the residence. The income relief provided is capped at $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 §108(a)(1)(E) will be applied to reduce the basis of the taxpayer's principal residence, but not below zero. This could result in a higher amount of capital gains tax owed by the taxpayer.

California Mortgage Debt Forgiveness Relief

California law, SB 401, conforms California Revenue and Tax Code Section 17144.5 to federal law, but with the following changes:

(1) The maximum amount of qualified principal residence indebtedness is $800,000 for married couples filing jointly, registered domestic partners filing jointly, single persons, head of household, widow/widower; and $400,000 for married couples or registered domestic partners filing separately; and

(2) The maximum amount of debt relief income that can be forgiven is $500,000 for married couples filing jointly, registered domestic partners filing jointly, single persons, head of household, widow/widower; and $250,000 for married couples or registered domestic partners filing separately; and

(3) California’s debt relief statute applies to property sold on or after Jan. 1, 2009 and before Jan. 1, 2013.

Qualifying taxpayers who have already filed their 2009 California tax returns should file Form 540X, Amended Individual Income Tax Return , to subtract the amount of debt relief from income. To expedite processing, write "Mortgage Debt Relief" in red across the top of the amended tax return. Taxpayers must attach a copy of their federal return, including Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment) , with their state tax return.

Capital Gains Income

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 an investment property (or to buy a car, to take a vacation, consolidate credit card debt, 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 (see the example below).

The tax calculation for any capital gains income looks just like step one when calculating capital gains income for a foreclosure sale of recourse debt.

Example:

1. The unpaid balance 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 will 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 other exemptions from the taxation of cancellation of debt income?

A Yes. There are four other circumstances, in addition to what was discussed in Question 9, where the taxpayer can get relief from taxation on cancellation of debt income:

(1) The taxpayer is insolvent (the taxpayer's debts exceed their assets, but the cancellation of debt is forgiven only to the extent of the insolvency);

(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.

For all of the above, any reduction in indebtedness will be applied to reduce the taxpayer’s basis in the property.

(26 U.S.C. §§ 108(a), 108(b), 108(c) and IRS publication 908.)


Note, however, it is likely that many taxpayers currently subject to cancellation of debt income will qualify for the insolvency exemption from taxation. Taxpayers should be advised to speak with their own tax advisors as to whether they meet the insolvency exemption.

Q11. 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 married filing a joint return. This exclusion does not apply to ordinary income from cancellation of debt.

MISCELLANEOUS

Q12. 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.

Q13. What is a quick summary of these taxation rules?

	Recourse Foreclosure/ Deed-in-Lieu	Nonrecourse Foreclosure/ Deed-in-Lieu	Short Sale
Capital Gains	FMV Less Adjusted Basis	Greater of FMV or Outstanding Debt Less Adjusted Basis	FMV Less Adjusted Basis
Ordinary Income	Outstanding Debt Less FMV *	No Ordinary Income	Amount of Debt Forgiven*

*No Ordinary Income if property is considered a "Qualified Principal Residence Indebtedness" (See the discussion in Question 9).

Q14. Does California follow the federal COD debt relief rules set forth above?

A Not exactly. California law, SB 401, conforms California Revenue and Tax Code Section 17144.5 to federal law, but with the following changes:

(1) The maximum amount of qualified principal residence indebtedness is $800,000 for married couples filing jointly, registered domestic partners filing jointly, single persons, head of household, widow/widower; and $400,000 for married couples or registered domestic partners filing separately; and

(2) The maximum amount of debt relief income that can be forgiven is $500,000 for married couples filing jointly, registered domestic partners filing jointly, single persons, head of household, widow/widower; and $250,000 for married couples or registered domestic partners filing separately; and

(3) California’s debt relief statute applies to property sold on or after Jan. 1, 2009 and before Jan. 1, 2013.

Q15. 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. For more information, see IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments, and IRS Web page,The Mortgage Forgiveness Debt Relief Act and Debt Cancellation.
^. 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.

This legal article is just one of the many legal publications and services offered by C.A.R. to its members. For a complete listing of C.A.R.'s legal products and services, please visit www.car.org.

Readers who require specific advice should consult an attorney. C.A.R. members requiring legal assistance may contact C.A.R.'s Member Legal Hotline at (213) 739 8282, Monday through Friday, 9:00 a.m. to 6:00 p.m. and Saturday, from 10 a.m. to 2 p.m. C.A.R. members who are broker-owners, office managers, or Designated REALTORS® may contact the Member Legal Hotline at (213) 739 8350 to receive expedited service. Members may also submit online requests to speak with an attorney on the Member Legal Hotline by going to http://www.car.org/legal/legal-hotline-access/. Written correspondence should be addressed to:

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FORECLOSURE VS SHORT SALE

Foreclosure - What Gets Affected?

CREDIT SCORE - Credit score may be lowered anywhere from 250 to over 300 points and will typically affect the credit score for minimum of 3 years.

CREDIT HISTORY - A foreclosure will remain as a public record on a person's credit report for 10 years or more.

FUTURE MORTGAGE LOANS - A homeowner who has a foreclosure is ineligible to purchase for 5 years. 7 years for investment property.

DEFICIENCY JUDGMENTS - Banks can pursue a deficiency balance on 100% of foreclosures - unless it was a purchase money loan

Short Sale - What Get Affected?

CREDIT SCORE - Only the late payments will show up after the sale of the mortgage. Bureaus will report PAID or NEGOTIATED. The credit score will not go down as much and can be as brief as 12 to 18 months.

CREDIT HISTORY - Short Sale is not reported on a person's credit history! There's no specific term for short sale and it will be reported as PAID IN FULL OR SETTLED.

FUTURE MORTGAGE LOANS - A homeowner or investor who does a short sale will be eligible to purchase another home in as little as 2 years.

DEFICIENCY JUDGMENTS - In a successful short sale, it's possible to get the bank to release the homeowner of any deficiency balance and to waive any rights to pursue a judgment in the future. Some homeowners will qualify for a new program called HAFA and in that case the bank must release the homeowner of any deficiency balance and legally can't pursue you in the future. Plus they will give you money for moving expenses to relocate you and your family to a new home.

SELLING EXPENSES - When you list your home with a Realtor, the agent you hire will take on all the marketing expenses and the bank will cover ALL the fee's incurred to sell. That includes Realtor commissions, Title Fee's, Escrow Fee's and many more normal seller expenses. It cost you ZERO dollars to sell the house and it's so much better for your financial future.

Facing foreclosure is a scary time and can be very stressful on you and your family. You need to know that you have options!! The choices you make today can affect your financial circumstances for many years to come. LET ME HELP GUIDE YOU THROUGH YOUR CHOICES. Each homeowners circumstances are different and each outcome is different, but one this is for sure......you have options and you need to know what they are!! I will come to your home and walk you through your options at NO COST to you.

Call me today and I will be there to help you and your family! IT'S AT NO COST TO YOU AND CAN SAVE YOU FROM TOTAL FINANCIAL COLLAPSE.

I can be reached at (951) 315-6255 or email at mylocalrealtor@aol.com

1. Mortgage insurance premium (MIP) will be increased to build up capital reserves and bring back private lending
   • The first step will be to raise the up-front MIP by 50 bps to 2.25% and request legislative authority to increase the maximum annual MIP that the FHA can charge.
   • If this authority is granted, then the second step will be to shift some of the premium increase from the up-front MIP to the annual MIP.
   • This shift will allow for the capital reserves to increase with less impact to the consumer, because the annual MIP is paid over the life of the loan instead of at the time of closing
   • The initial up-front increase is included in a Mortgagee Letter to be released tomorrow, January 21st, and will go into effect in the spring.
     
     
2. Update the combination of FICO scores and down payments for new borrowers.
   • New borrowers will now be required to have a minimum FICO score of 580 to qualify for FHA's 3.5% down payment program. New borrowers with less than a 580 FICO score will be required to put down at least 10%.
   • This allows the FHA to better balance its risk and continue to provide access for those borrowers who have historically performed well.
   • This change will be posted in the Federal Register in February and, after a notice and comment period, would go into effect in the early summer.
     
     
3. Reduce allowable seller concessions from 6% to 3%
   • The current level exposes the FHA to excess risk by creating incentives to inflate appraised value. This change will bring FHA into conformity with industry standards on seller concessions.
   • This change will be posted in the Federal Register in February, and after a notice and comment period, would go into effect in the early summer.
     
     
4. Increase enforcement on FHA lenders
   • Publicly report lender performance rankings to complement currently available Neighborhood Watch data - Will be available on the HUD website on February 1.
     • This is an operational change to make information more user-friendly and hold lenders more accountable; it does not require new regulatory action as Neighborhood Watch data is currently publicly available.
   • Enhance monitoring of lender performance and compliance with FHA guidelines and standards.
     • Implement Credit Watch termination through lender underwriting ID in addition to originating ID.
     • This change is included in a Mortgagee Letter to be released tomorrow, January 21st, and is effective immediately.
   • Implement statutory authority through regulation of section 256 of the National Housing Act to enforce indemnification provisions for lenders using delegated insuring process
     • Specifications of this change will be posted in March, and after a notice and comment period, would go into effect in early summer.
   • HUD is pursuing legislative authority to increase enforcement on FHA lenders. Specific authority includes:
     • Amendment of section 256 of the National Housing Act to apply indemnification provisions to all Direct Endorsement lenders. This would require all approved mortgagees to assume liability for all of the loans that they originate and underwrite
     • Legislative authority permitting HUD maximum flexibility to establish separate "areas" for purposes of review and termination under the Credit Watch initiative. This would provide authority to withdraw originating and underwriting approval for a lender nationwide on the basis of the performance of its regional branches