Legal Question in Real Estate Law in California

1) The answer depends upon the nature of the loans, whether they were purchase money [then no deficiency] or not. You can look at the prior answers on this site as to that frequently asked question.

2) The lender does not have to report it as income but may and you might have to pay taxes but there are some ways to decrease the tax burden.

1. Not on your primary residence. On your rental property, it depends.

2. Yes and maybe yes.

3. See a bankruptcy attorney right away.

1. They can only come after you for the difference if they file a judicial foreclosure lawsuit, and on the personal residence if the loan was a refi or for some reason not 100% of the loan was used for the original purchase of the house. Because the judicial foreclosure lawsuit takes so much longer, and the sale is subject to all kinds of restrictions and pitfalls, and costs so much more, I have never known a commercial lender to foreclose that way in the absence of fraud or other much more serious issues than just a defaulting borrower. Once they elect to foreclose by trustee's sale under the deed of trust, they are barred by the "one form of action" rule from pursuing you for any unpaid balance.

2. The IRS does indeed consider the difference between what you owe and what the property brings at the trustee's sale to be income. There are, however, qualified exclusions that allow you not to pay taxes on it. You would need to talk to a tax accountant to make sure the exclusions apply to you. If the exclusions apply, you wouldn't need an attorney, and if they do not apply, an attorney would be very unlikely to be able to help you.

1. As to #1, I agree with Mr. McCormick and would guess that your chances of being sued rather than foreclosed by trustee sale are less than 1 in 10,000 on your primary residence and less than 1 in 100 on the income property. The factors that might increase your risk would include (a) the lender is an individual or a small organization rather than a big financial institution and can't afford a loss and/or isn't very smart; (b) the loan documentation was defective so that the lender lacks a valid deed of trust; (c) the lender has decided it hates you because you have committed fraud or waste or otherwise have irritated it.

2. As to #2, while the IRS often can treat loan "forgiveness" (i.e., the lender's loss upon a foreclosure sale for less than the amount owned) as imputed income to the erstwhile borrower, the borrower will often have offsetting captail or other losses. The borrower's tax advisor can be helpful here, or ask the IRS for assistance.

I am writing to respond to a voicemail I received from the questioner. He indicated that both loans were refinanced and that the loans are with a large commercial lender. That makes only a little difference to the answer. It just means that both the rental and personal residence COULD be the subject of a foreclosure lawsuit rather than a trustee's sale. The likelihood of the lender choosing to sue on the debt, rather than process a default and trustee's sale are still extremely remote unless, as Mr. Whipple mentioned, there are defects in the loan paperwork the lender accuses you of something more than just not paying back the loan.

I also feel the need to correct Mr. Whipple on part 2. The IRS not only "often can" treat any uncollectable deficiency as income, the IRS WILL do so, unless the lender for some reason does not report it. Given that the lender cannot deduct the loss if they don't report it, and you are dealing with a large bank that knows how to take its deductions, you will receive a 1099-C for each of the loans for the difference between the trustee's sale amount and the amount owed, including fees, expenses, etc., that get tacked onto the loan in a foreclosure. Under the tax code that is ordinary income to you. As I said, however, there are exemptions and exclusions you can claim to avoid that income hitting your adjusted gross income and being taxed. The two that probably apply to you are the "qualified personal residence" and the "qualified business real property" exemptions. Consult an accountant about exemptions and exclusions. If they think it is a close enough call as to whether you qualify, they can refer you to a tax attorney. My bet is you definitely qualify for the personal residence exclusion unless your house was worth $2 million or more; and you probably qualify for the business real property exemption too on the rental.