Thinking About a Short Sale or Foreclosure?
/The Law you Should Know
Before you consider a short sale or foreclosure, here is the law you should know.
First, there are two types of debts. They are unsecured and secured. Unsecured debt is the bare promise to pay. The most common form is credit card debt. Secured debt, on the other hand, has two parts. The first part is the bare promise to pay which on a car loan or real estate loan is the Promissory Note. What makes secured debt different than unsecured debt is the security given by the borrower to ensure the promise is kept. This security on real property is called a Deed of Trust and on a car loan it is the lienholder on the Certificate of Title. Second, on real estate loan, there are two different types of promises to pay. Non-Recourse or Recourse. A Non-recourse loan is (1) the loan or loans obtained to purchase a 1-4 unit property in which the borrower occupies at least one unit or (2) seller carry back. Everything else is recourse debt i.e. the refinance of the real property, lines of credit, the loan or loans used to purchase a rental property.
Third, under California law, a short sale or foreclosure can stay on a credit report for up to 7 years. Fourth, personal liability depends on whether you do a short sale or foreclosure. If you do a short sale, you can have personal liability unless it is waived by the lender. Remember, a short sale is just like any other sale and if you don’t pay the full amount, the lender can request payment. If you allow your property to be foreclosed in a non-judicial foreclosure sale, you will not have any personal liability as to the loan that is foreclosed on because California is an anti-deficiency state i.e. the lender waives its right to come after you on the loan that they foreclosed on. However, if there are junior liens to the foreclosing lien, they will have the right to sue you after the foreclose. They are called “sold out” junior i.e. they lost their lien, but they still have the promise to pay and thus have the right to sue you on the promissory note. Fifth, in every short sale or foreclosure, there are tax implications. The IRS wants to know two things. They are (1) did you make any money on the deal and (2) did you borrow any money which was not repaid. If you made money on the deal including taking out cash to buy another house, buy another car, pay off credit card, you may have gain. If you borrowed money which is not repaid either through a short sale or foreclosure, you may Cancellation of Debt Income (“CODI”). There are exceptions to the CODI, but be very cautious of tax implications because it is a very complicated area of the law.
In conclusion, a short sale or foreclosure without tax and legal advice is like jumping into the middle of the ocean with no life vest. Don’t do it. The California Association of Realtor is so concerned about this issue that the Short Sale Addendum specifically tells sellers to obtain tax and legal advice prior to proceeding with a short sale. Help is available to you. Do not take on personal liability or tax liability which could have been eliminated through a bankruptcy or reduced with first obtaining tax and legal advice.