Unemployment and depressed home values have burdened American homeowners over the past few decades, resulting in a historic increase of mortgage defaults. The lending market has responded to the crisis by negotiating plans with defaulting borrowers which include the settlement of their outstanding loans through a”short sale.”

Home Loan Default

When home prices were appreciating, owners who sold their houses paid off the accounts on their outstanding loans and pocketed any surplus as profit. Back in California, the seller’s trust deed involves a”due on sale” clause which pays the lender the outstanding balance of this loan prior to other sales-related costs are distributed. Any cash that remains is the seller to maintain as his profit. In this depressed housing market, though, a property will probably sell for less cash than what is required to pay back the loan. The seller would be obligated to pay the gap between the sales price and the outstanding loan balance to the lender. Regrettably, recent economic woes have left lots of Californians jobless and unable to pay their monthly mortgage obligations. Unable to sell their houses and pay any shortfall to their lender, they thus face foreclosure.

Short Sale

Many lenders prefer to utilize their defaulting borrowers by agreeing to sell the properties as”short sales” rather than sell them at auction as foreclosures. Though short sales are cumbersome and take the time to complete, lenders prefer them to foreclosures. The expense of foreclosing on properties is large, and lenders risk the added expense of taking ownership of them as REO (Real Estate Owned) possessions in the event that they fail to sell. Lenders subsequently incur the additional expenses of maintaining them, in addition to the expense of marketing and selling them at a later time. Following a short sale, lenders accept the money in the sale even though it will be”short” of the amount required to pay back the loan. By accepting short sale proceeds, lenders offset the accounts of their debt.

IRS Filing

According to existing federal statutes, a lender must issue Type 1099-C, Cancellation of Debt, to a borrower by imagining that the forgiven amount in box 2 of this form. The borrower needs to include that amount on his federal income tax return and attach Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. If the lack amount is canceled following a short sale, only line 1c and two need be completed. If the loan is restructured by the lending company, however, and the debtor is permitted to stay in the property, line 10b also has to be completed.

Mortgage Debt Relief Act of 2007

Though a home mortgage is a relief to borrowers who are unable to make their monthly mortgage payments, the requirement to pay income tax on the forgiven amount might be troublesome if it weren’t for the Mortgage Debt Relief Act of 2007. The law allows married taxpayers filing jointly to exclude up to $2 million ($1 million if single or married filing separately) of their earnings derived from the release of their debt on a principal residence, beginning in 2007 through 2012.

Section 580b

Though a lot of borrowers were more relieved to have drop their unmanageable home loans through short sales, they were often sued by their lenders to get a deficiency judgment on the outstanding balances that a short sale did not pay for. Under California Code of Civil Procedure, Section 580b, nevertheless, California borrowers can’t be sued by their lenders to get a deficiency judgment on purchase-money loans which weren’t paid off with a short sale.

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