Foreclosures and Short-Sales – Part III – Recourse and Nonrecourse Debt

Originally published in the Pacific Grove Hometown Bulletin

July 20, 2011

The last two issues I went over the basic concepts of foreclosures, short-sales, and an overview of excluding the related income and what you give up in return. If you missed these articles they are re-published on my website at www.tlongcpa.com/blog.  This issue I was intending to discuss the exclusion available to people losing their principal residence, but I am going to bump that to the next issue in order to cover one other fundamental concept – recourse and nonrecourse debt.

Recourse debt means that you are personally liable for the debt and the lender has the right to pursue you for the full balance of what you owe if the home is not enough to satisfy the debt you owe.  Nonrecourse debt means the lender has agreed, in event of default, to take the house as full settlement for the debt, and they cannot pursue you for the amount you are deficient.  This effectively means there is no debt for them to cancel, which means you can have no taxable income from cancelled debt.  Clearly, you hope your debt is nonrecourse!  How do you know?

Actually, if you have never refinanced your property, it is almost certainly nonrecourse.  Hooray!  This is due to the California anti-deficiency laws in California Code of Civil Procedures Section 580(b) which essentially makes it illegal for lenders to pursue borrowers for a deficiency on original purchase loans.  Unfortunately these same provisions do not apply if you refinanced, and you will almost always find those loans to be recourse. Un-hooray.

Even with a recourse loan, it is rare to hear of lenders pursuing the deficiency because they do not find it particularly cost effective (think legal fees) or good press to sue someone who just lost a home and has a family to support with no job.  It is often simpler for the lender to cancel the debt, take a loss, and write-it off as a bad debt on their tax returns.

There are two tax documents you may receive in the process of losing a property through foreclosure or short-sale.  A 1099-A is a tax notification that you have given up or “A”bandoned the property. The other document is a 1099-C which should be issued if the lender “C”ancels a recourse debt.  Both of these include the lender’s idea of its fair market value and if you are personally liable.  Both are notoriously incorrect assuming you receive them at all.  The 1099-C also includes the amount of debt you owed when cancelled.   A savvy tax professional will recognize these issues can affect your taxes and will help you take appropriate action.  If you have a foreclosure or short-sale looming, get help early.

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

Travis H. Long, CPA is located at 706-B Forest Avenue, Pacific Grove, CA, 93950.  He can be reached at 831-333-1041.

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