The California Rules or “So What Happens If I Let My California House Go Back To The Bank?”
I get this question a lot. The answer is, IT DEPENDS. That’s a slimy lawyer’s response (someone called me that yesterday) but the outcome in your situation could be:
1. You still owe the bank a big slug of money;
2. You have a big income tax bill with no cash to pay it;
3. You owe the bank a big slug of money and you have a big tax bill ; or
4. You owe the bank nothing and you do not have a tax bill.
Everyone wants to be the last case. A lot of my clients show up to my office as the third case. The good news is most people can be the last, but only IF THEY PLAN CAREFULLY!!!
This brings me to Jim Cramer. I like Cramer because he brings raw institutional investor insights to the masses. He tells the brutal truth and I respect that. But I was really pissed off when he cavalierly advised his fans to “walk away” from their houses. I don’t fault his economics: if your house is sucking all your money from you why throw good money after bad on it? But you can really hurt yourself financially if you do not “walk away” carefully.
So I have set out below the rules that you need to take into account when you let your house go. They are really complicated and are too complicated for you to figure out on your own so GET PROFESSIONAL ADVICE TOO BEFORE YOU DO SOMETHING STUPID.
THE CALIFORNIA RULES:
1. THE PURCHASE MONEY RULE: In California, a lender who loaned you money to BUY your home, which you ORIGINALLY moved into as your primary residence, cannot do anything other than foreclose. This means if the foreclosure sale does not pay all “purchase money” loans, those lenders cannot sue you for the unpaid balance. Most importantly, this includes second mortgages used in many 80/20 100% financing deals. If you REFINANCED any of these loans, or paid down purchase money HELOC and drew down on it again, this rule does not apply.
2. THE ONE ACTION RULE: In California, a mortgage lender can only take one action against you: A non-judicial foreclosure, or a judicial foreclosure. A non-judicial foreclosure is just like the PURCHASE MONEY RULE, a lender can only sell the property to pay the loan. If the sale does not pay the mortgage, the foreclosing lender cannot get the unpaid balance from you. However, the lender can get the balance from you in a judicial foreclosure. The good news is judicial foreclosures are too uncertain and costly for lenders that they are almost non-existent. BUT, (pay attention, this is important) if a lender’s security interest is wiped out by a senior mortgage foreclosure, the junior lender can obtain a deficiency judgment for their unpaid balance because they have not had their ONE ACTION against you yet (subject to the PURCHASE MONEY rule of course). This situation is very common these days for that second mortgage you used to remodel the kitchen and bathroom.
3. THE CANCELLATION OF DEBT RULE: Both the IRS and California tax you for the amount of debt that is CANCELLED in any given tax year. Debt is cancelled only when a lender has given up on its right to collect the debt or they are barred by law from collecting the debt (think PURCHASE MONEY & ONE ACTION rules).
4. THE BANKRUPTCY & INSOLVENCY EXCEPTION. Both the IRS and California exclude cancelled debt from your income to the extent the debt was CANCELLED in bankruptcy or you were insolvent; BUT ONLY TO THE EXTENT OF YOUR INSOLVENCY!!!! You are insolvent when your debts exceed your assets. Assets include IRA and pensions.
So, think you know the rules? Let’s try a few examples and see how you do. Answers & explanations are below.
Example 1: Mike borrowed an $800k first and a $200k second loans to buy a beach condo he stays at on the weekends and rents out occasionally. The first foreclosed (non-judicial) and paid off only $750k of the first loan. The second was wiped out. What happens?
A. Mike walks away without any debt to the first or second loans because it was “purchase money” debt;
B. Mike has income from the cancellation of debt of $50k on the first and all of the second;
C. Mike owes the second the entire balance and has $50k cancellation of debt on the first mortgage;
F. Mike can’t surf so it does not matter.
Example 2: Mike got a $200k first loan to buy his house and later took a $400k second to add a go-cart track and skate board ramp. The SECOND foreclosed (non-judicial) and just paid off the first loan. The second was wiped out. What happens?
- Mike walks away without any liability to the first or second loans.
- Mike has income from the cancellation of debt on all of the second loan;
- Mike has no cancellation of debt income;
- Mike can’t surf so it does not matter.
Example 3: Mike got an $800k first loan and $200k second to buy his home. The second was a HELOC that he paid off then borrowed against to buy land in front of a great surf break. The first foreclosed (non-judicial) and just paid off the $750k of the first loan. The second was wiped out. What happens?
- Mike walks away without any debt to the first or second loans.
- Mike has income from the cancellation of debt of the second loan;
- Mike has no cancellation of debt income;
- Mike can’t surf so it does not matter.
Example 4: Same example as three, expect that just prior to the foreclosure, Mike had (in addition to his house debts) $10,000 in cash and no other debts. What happens?
- Mike is taxable on the entire $50k CANCELLATION of debt from the first loan because he is not insolvent.
- Mike is taxable on $10k of his CANCELLED debt;
- Mike has no CANCELLATION of debt income;
D. Mike can’t surf so it does not matter.
1. C & F are correct. The loans are “purchase money” but because Mike did not move into the condo and make it his home when he got the loan, the purchase money rule does not apply (WARNING Ask your attorney about the rare VENDOR RULE). The second can sue for the balance because it has not yet taken its ONE ACTION and is thus not CANCELLED. The first is $50k short and it cannot sue Mike for the balance because it took its ONE action so the debt is now CANCELLED and is taxable income. F is always true.
2. D & F are correct. The first loan was paid and thus there is neither deficiency nor cancellation of debt. The second loan was not a “purchase money” because the loan (although put to great use) was not used to buy the house. BUT, the second foreclosed so it used its ONE ACTION and cannot get a deficiency. Because the second cannot get a deficiency, the debt is now cancelled and is now taxable income. F is always true.
3. Only F is correct. The first loan was used to buy the home and it foreclosed so both the ONE ACTION and PURCHASE MONEY rules apply to prevent the first from getting a deficiency for the $50k. But $50k of the balance is CANCELLED and thus taxable income. The second was not a purchase money loan because the second set of loan proceeds were not used to buy the home. The second did not take an action so it can still sue Mike for a deficiency. Because the second can still sue Mike, it is not CANCELLED and thus not taxable income. F is always true.
4. C and D are correct. Mike is insolvent. Mike has $760k in assets (house + cash) and $1 million in debt so his liabilities are in excess of his assets and thus his income is excluded. Had mike just had an $800k first mortgage, he would have been taxable on $10,000 of the debt because without the forgiven debt, he would have $10k in assets. So he the tax is excluded only TO THE EXTENT OF THE INSOLVENCY. D is always true.
Written By Shawn Doan-Mr. Doan has successfully litigated hundreds of claims against credit card companies that willfully violate the bankruptcy code and other state and federal laws designed to protect consumers. Shawn’s present and past professional affiliations include being a member of the Consumer Attorneys of San Diego, American Bar Institute, Bar Association of North County, Association of Trial Lawyers of America, National Bankruptcy Institute, National Association of Consumer Bankruptcy Attorneys, American Bankruptcy Institute, North County Attorney Referral Service, and San Diego County Attorney Referral Service.
Quality San Diego Bankruptcy Attorneys can be hard to find these days, but over at Doan Law Firm we take pride in the quality of our work and our clients are our number one priority.