James R. Balmforth: Post-Foreclosure Liability For Taxes

Utah foreclosures tend to be non-judicial, which means they happen outside of court. Judicial foreclosures, which go through the court system, are also possible. Because foreclosures in Utah are typically non-judicial, this article focuses on that process. Before the bank or servicer (the company that handles mortgage accounts on behalf of the bank) can officially start the foreclosure, it must mail the borrower a notice of intent to file a notice of default. In most cases, under federal law, a servicer must wait until the borrower is over 120 days’ delinquent before officially starting the foreclosure process. To officially start the foreclosure, the trustee (the third party that administers non judicial foreclosures) records a notice of default in the county recorder’s office at least three months before giving a notice of sale. The trustee mails a copy of the notice of default within ten days after the recording date to anyone who requested a copy. (Most deeds of trust in Utah include a request for notice, so borrowers typically get this notification.)

“Reinstating” is when the borrower catches up on the defaulted mortgage’s missed payments, plus fees and costs, to stop a foreclosure. Utah law provides the borrower with a three-month reinstatement period after the bank or trustee records the notice of default. Also, the loan contract might give you more time for completing a reinstatement. Check the paperwork you signed when you took out the loan to find out if you get more time to bring the loan current and if so, the deadline to reinstate. When the total mortgage debt exceeds the foreclosure sale price, the difference is called a “deficiency.” Some states allow the foreclosing bank to seek a personal judgment, which is called a “deficiency judgment,” against the borrower for this amount. Other states prohibit deficiency judgments with what are called anti-deficiency laws. In Utah, the foreclosing bank may obtain a deficiency judgment following a non-judicial foreclosure by filing a lawsuit within three months after the foreclosure sale. In order to fully grasp the information in this post, it’s important to understand the basics of a mortgage. Most people say “I’m paying my mortgage.” What they actually mean is that they’re paying their note.

The mortgage is the legal instrument that gives your lender the right to foreclose when you don’t pay the note, which is the instrument that evidences the debt. Mortgage and note are two separate things. This is an important distinction because in many jurisdictions, lenders have two ways of getting their money back from a homeowner who has fallen behind: they can either foreclose and sell the property OR try to enforce the note by suing the borrower personally. Sometimes they’ll try doing both at the same time, but not in Utah thanks to the one action rule. In Utah, lenders are prohibited from simultaneously suing for the outstanding mortgage balance and foreclosing at the same time. A judicial foreclosure must take place in the same action as the pursuit of a deficiency judgment. Only after the proceeds from the foreclosure sale have been applied to what owed can a lender is seeking a judgment on the remaining debt. To put it in plain English, when you get behind on your mortgage, your lender must foreclose first; they cannot sue you personally or attach money in your bank accounts before they have foreclosed on your home. Known as the “security first” rule, the law is intended to shield Utahans from multiple harassing lawsuits by lenders. Be aware that the one action rule does not apply in cases where a second mortgage lender’s security interest has been wiped out due to the first mortgage lender foreclosing. The first requirement, that you live in your home, is easy to understand and satisfy. The Utah anti-deficiency law is meant to shield homeowners from deficiency judgments, not investors. If you are the owner of a 100 unit apartment building and live in one of the units, your lender will still be able to seek a deficiency after foreclosure. In this example, you’re obviously a real estate investor.

If, on the other hand, you live in your home and rent out an apartment upstairs, your lender cannot seek a deficiency because your home only constitutes two units. The mortgage is the legal instrument that gives your lender the right to foreclose when you don’t pay the note, which is the instrument that evidences the debt. Mortgage and note are two separate things. This is an important distinction because in many jurisdictions, lenders have two ways of getting their money back from a homeowner who has fallen behind: they can either foreclose and sell the property or try to enforce the note by suing the borrower personally. Sometimes they’ll try do both at the same time, but not in Utah thanks to the one action rule. First and foremost, a lender cannot sue a borrower for a deficiency judgment where the foreclosure sale price is high enough to satisfy the outstanding mortgage balance.

By definition, a deficiency judgment arises when a home is underwater, the bank forecloses and the sale price is insufficient to pay back the mortgage balance. If your home sells at foreclosure for more than what you owe, there is no deficiency and can therefore be no deficiency judgment. As a practical matter, the scenario where a foreclosure sale completely satisfies the mortgage debt simply won’t apply to most Utah homeowners who are underwater on their property thanks to the national housing downturn. Assuming your home is underwater and you’re facing foreclosure in Utah, we’ll move on to the next important set of facts, which deal with the type of mortgage you have and the size of your property. If a mortgage is given to secure the payment of the balance of the purchase price, or to secure a loan to pay all or part of the purchase price, of a parcel of real property of two and one-half acres or less which is limited to and utilized for either a single one-family or single two-family dwelling, the lien of judgment in an action to foreclose such mortgage shall not extend to any other property of the judgment debtor, nor may general execution be issued against the judgment debtor to enforce such judgment, and if the proceeds of the mortgaged real property sold under special execution are insufficient to satisfy the judgment, the judgment may not otherwise be satisfied out of other property of the judgment debtor, notwithstanding any agreement to the contrary.

What does this legalese mean? Well, a mortgage is given to “secure the balance of the purchase price” of a home when you take out a mortgage to finance your property. If you’re like most of us and couldn’t afford to buy your home in cash, you relied on mortgage financing to buy your house. If you did, the Utah legislature believes that your lender shouldn’t be permitted to sue you for a deficiency and come after your personal assets after they’ve foreclosed on you. As long as your property is 2.5 acres or less in size and you used mortgage financing to purchase the property, you’re protected from a deficiency judgment. This provision adds an additional layer to the Utah anti-deficiency laws. Foreclosure by power of sale is a quick, inexpensive way for lenders to take back property; however, because there is no judicial oversight, the process is more highly scrutinized by the court. In this regard, Utah law says that a bank can foreclose by power of sale, but if they do they will not be permitted to seek a deficiency judgment. How do you know whether your home is subject to power-of-sale foreclosure? Although Utah allows both judicial foreclosure and power of sale foreclosure, power of sale is the most common. Look at your mortgage documents: If you have a Deed of Trust, your lender is entitled to foreclose by power of sale. It should be noted that the 2.5-acre requirement applies in the power of sale legislation just as it does in other areas. It is important to keep in mind that while Utah’s anti-deficiency laws are consumer-friendly, they are not uniform in application. There are limits to the protections from deficiency a judgment not only to purchase money mortgages and properties that are smaller than 2.5 acres in size, but also requires that the number of dwelling units not exceed two.

This limitation was put in place to protect homeowners from deficiency judgments while classifying real estate investors separately from homeowners. A non-recourse loan is one where the borrower isn’t personally liable for repayment of the loan. In other words, the loan is considered satisfied and the lender can’t pursue the borrower for further repayment if and when it repossesses the property. The figure used as the sales price is the outstanding loan balance immediately before the foreclosure of a non-recourse loan. The IRS takes the position that you’re effectively selling the house back to the lender for full consideration of the outstanding debt, so there’s generally no capital gain. The Mortgage Forgiveness Debt Relief Act of 2007 (MFDRA) provided that taxpayers could exclude from their taxable incomes up to $2 million in discharged mortgage debt due to foreclosure a nice tax break indeed. Prior to 2007, discharged debt was included in taxable income. Then the MFDRA expired at the end of 2017, so discharged debt was once again considered to be taxable income by the IRS. Fortunately, this provision of the tax code is back again, at least for foreclosures that occur from Jan. 1, 2018 through Dec. 31, 2020. Title I, Subtitle A, Section 101 of the Further Consolidation Appropriations Act of 2020, signed into law by President Trump in December 2019, extends this provision through the end of 2020.5. If you’ve lost your home through foreclosure, you may still be on the hook for taxes. This can happen if the foreclosure sale price is less than the amount you owed on your mortgage or other liens against your home. The extra amount you owe is called the deficiency. If the deficiency amount is forgiven or cancelled by the mortgage lender, then the IRS or state taxing authority might treat the forgiven debt as income, and then you’ll have to pay taxes on it. The same principles apply with short sales. Fortunately, at least through 2013, most people who lost their homes through foreclosure will not face income tax liability. This is thanks to the federal Mortgage Forgiveness Debt Relief Act of 2007. But there are some exceptions, and some people might face capital gains tax. When your foreclosure includes a cancellation of debt, you only have an obligation to report it as ordinary income if you were personally liable for the entire mortgage, despite the security interest your lender takes in the home. This amount will be reported in Box 2 of a 1099-C that the lender will send you.

You also need to calculate the capital gain that results from the foreclosure. To calculate the gain, subtract your tax basis in the home generally the purchase price plus the cost of home improvements you make from the home’s fair market value. However, if you’re not personally liable for debt that remains, use the outstanding mortgage balance at the time of foreclosure instead of the home’s fair market value. Similar to a foreclosure, any debt that your mortgage lender cancels because of a short sale is taxable only if the terms of your mortgage hold you personally liable for the full amount of the loan. Regardless of the tax consequences, your lender will report the debt cancellation on a 1099-C form. Through the end of 2019 you may have been eligible to exclude canceled debt from your tax return if it related to qualified principal residence indebtedness and met the requirements of the Mortgage Forgiveness Debt Relief Act. This could have also been applicable to debt that was discharged in 2020 provided that there was a written agreement entered into in 2019. Mortgages include those you obtained to buy, build or substantially improve a home and for which the lender retains an interest in the home until it’s paid off. A longstanding principle of tax law treats any type of debt forgiveness as a financial benefit, even if it comes at the expense of your home. This means that even if you are facing foreclosure you may incur an additional debt to the government, either in the form of Cancellation of Debt Income, or in the form of Gain from Foreclosure.

It is up to you to know what exceptions can eliminate the burden of Cancellation of Debt income. For example, debt forgiveness is not taxable if you’re insolvent. If you’re filing for bankruptcy and going through home foreclosure at the same time, you may not need to worry about additional tax liability. There is a distinction between those who can’t avoid foreclosure and those who choose foreclosure as an escape from a bad investment. “The only people I see getting burned by this have significant other investments “They are making a decision to let it go instead of paying for a bad asset.” Goold says there is another, lesser-known exception. The reason it is lesser known, perhaps, is that it is hard to take advantage of. In some circumstances, your bank may be willing to restructure your loan to reduce the principal. The government does not consider this taxable debt forgiveness, and it may just allow you to keep your home. The problem, of course, is that banks might have difficulty seeing the benefit of writing off part of your debt. You may be in a good position to enter this kind of negotiation if your mortgage is with a local community bank where you have personal relationships. If you choose to “short sell” for less than your home is worth, you should be aware that banks will not likely process the transaction immediately.

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