The DirtLaw Blog

A look back at 2009 - California's Foreclosure Laws

It's no surprise that in the current economic climate that California's government officials have made more law to tackle the foreclosure volume.  In late 2008, we saw the passing of emergency legislation, S.B. 1137, which amended California Civil Code 2923 et seq. to include an additional contact requirement to offer loan modifications to borrowers.  With S.B. 1137, lenders or their loan servicers had to attempt contact with the borrower on multiple occasions before recording the Notice of Default.

That piece of legislation essentially increased the time non-judicial foreclosure timeframe from four months to five months.

In 2009, California's Foreclosure Prevention Act almost doubled the time for foreclosure by imposing an additional 90 day moratorium on foreclosures.  The theory is that after the Notice of Default is filed, the normal 90 day reinstatement period will double to 180 days to give the borrower and lender time to work out a loan modification. 

The Act only applies to first loans, so Home Equity Lines of Credit (HELOC) and other junior liens are exempt.

The downside I see from this moratorium is that potential for "shadow inventory" created by all the loans in default where the borrower has no intention of continuing on the loan due to the loss of equity in the property.  It will take much longer now for those properties to be re-enter the market, which could prolong the price uncertainty for these homes.  Only time will tell.

TILA Rescission – Part II

We are defending TILA rescission claims with regularity these days.  Before going into the merits on TILA rescission as a remedy, below is a short outline I have prepared on the Truth in Lending Act as it relates to mortgages:

TRUTH IN LENDING ACT of 1968

   I. What is it and Where is it found?

a. Part of the Consumer Credit Protection Act, found in 15 U.S.C. §1601 et seq.

b. Regulation Z – regs implementing the statute, codified in 12 CFR 226 (available online at FDIC website).

c.   Official Staff Commentary, found at Supp I of Reg Z

II. What is it For?

a. was designed to protect consumer borrowers from the "uninformed use of credit," 15 U.S.C. § 1601(a), ie uniform assessment of costs

b. Regulates loans secured by consumer’s principal dwelling

c.   Regulates credit card billing practices

    III. TILA Amendments: HOEPA (Home Ownership & Equity Protection Act of 1994)

a. Also called “Section 32” loans/mortgages because HOEPA is contained in Section 32 of Reg Z.

b. A loan is covered by the HOEPA if it meets the following tests:

    i. for a first-lien loan, that is, the original mortgage on the property, the annual percentage rate (APR) exceeds by more than eight percentage points the rates on Treasury securities of comparable maturity;

  ii. for a second-lien loan, that is, a second mortgage, the APR exceeds by more than 10 percentage points the rates in Treasury securities of comparable maturity; or

iii. the total fees and points payable by the consumer at or before closing exceed the larger of $583 or eight percent of the total loan amount. (The $583 figure is for 2009. This amount is adjusted annually by the Federal Reserve Board, based on changes in the Consumer Price Index.) Credit insurance premiums for insurance written in connection with the credit transaction are counted as fees.

c.   Requires special Section 32 Disclosures, including written notice stating the loan need not be completed.

    i. Regulates or in some cases prohibits: prepayment penalties, default interest rate increases, balloon payments, neg am loans, prepaid interest and due-on-demand clauses.

   IV. Recent Amendments – Mortgage Disclosure Improvement Act of 2008 (MDIA)

a. Effective July 30, 2009

    i. Earlier disclosures required

  ii. Not just “principal residence” – any dwelling

iii. loan may only close 7 days after the Good Faith Estimate has been mailed or delivered to the consumer.

iv. This 7 day period can only be shortened on consumer’s waiver due to “bona fide” personal financial emergency.

   v. GFE disclosure must be provided before any fee paid by consumer, except credit score application cost.

b. Effective January 30, 2011

    i. Additional disclosures for variable rate transactions

V. What’s a Covered Loan?

a. “consumer” defined as:

(h) The adjective “consumer”, used with reference to a credit transaction, characterizes the transaction as one in which the party to whom credit is offered or extended is a natural person, and the money, property, or services which are the subject of the transaction are primarily for personal, family, or household purposes. [15 U.S.C. §1602(h)

b. Prior to MDIA, early disclosures were required only consumer’s principal dwelling [see 12 CFR 226.2(a)(24)]

c.   Exemptions, TILA does not apply: [see 12 CFR 226.3]

    i. Business, commercial or agricultural purposes

  ii. Credit over $25,000 not secured by real property or a dwelling

iii. Student Loans

iv. Special topic – Official Staff Commentary §226.2(a)(11) states: Guarantors, endorsers, and sureties are not generally consumers for purposes of the regulation, but they may be entitled to rescind under certain circumstances and they may have certain rights if they are obligated on credit card plans.

   v. Special topic - “trusts” TILA applies to “natural persons” ie, not corporations, partnerships, unions, government agencies….and “trusts”

d. “Purposes” of the Loan – Stillman test more than 50% for consumer use.  “Where more than half the money loaned is for an exempt purpose, such as to fund a business, the disclosure requirements are deemed not to apply.” [Stillman v. First National Bank of N. Idaho, 117 Idaho 642, 791 P.2d 23(Idaho, 1990)] (But see Ninth Circuit Thorns factors below.)

    i. Thorns v. Sundance Properties (9^th Cir. 1984) 726 F.2d 1417    

1. The relationship of the borrower’s primary occupation to the acquisition.  The more closely related, the more likely it is to be a business purpose.

2. The degree to which the borrower will personally manage the acquisition.  The more personal involvement there is, the more likely it is to be a business purpose.

3. The ratio of income from the acquisition to the total income of the borrower.  The higher the ratio, the more likely it is to be a business purpose.

4. The size of the transaction.  The larger the transaction, the more likely it is to be a business purpose.

5. The borrower’s statement of purpose for the loan.

TILA violations? Part I

Dear Reader - I wrote this article a few years ago for the California Mortgage Association's Quarterly and it's still relevant today in the era of the "foreclosure defense" lawsuits.  I am often asked about Truth-in-Lending-Act (TILA) rescision and I thought I would republish this as the first in a series on the TILA topic.

_______________________________________________________________

Even After Refinancing a Loan, A Borrower Can Rescind That Loan for TILA Violations 

 

By Julia M. Wei

On April 27, 2006, the California Court of Appeal ruled that a borrower’s right to rescind the transaction for a Truth In Lending Act violation survives a refinancing of the offending loan.

In the case of Pacific Shore Funding v. Zoran Lozo, et al., the borrowers attempted to rescind their original loan transaction on the grounds that the lender had failed to comply with the disclosure requirements of the Truth In Lending Act.  Nearly three years had passed since the original loan transaction had occurred. 

The Lozos had obtained a non purchase-money loan for $28,000 from Pacific Shore at a rate of 13.375 percent.  Pacific Shore charged origination, funding, processing and settlement fees in excess of $2,800, amounting to more than ten percent of the loan.  Accordingly, this “high-cost” loan was subject to the disclosure requirements of TILA and Regulation Z.  Two years after this loan, the Lozos obtained a second loan from Pacific Shore for $71,600, a portion of which paid off the first loan to Pacific Shore and the prepayment penalty.

After the refinance, the Lozos made a demand to Pacific Shore Funding to rescind their original loan.  Pacific Shore Funding refused and sued the borrowers for a declaration that the loan agreement was valid.  The borrowers cross-complained, alleging violation of TILA and seeking damages.

The borrowers’ claim for rescission rested on the grounds that 1) on the Notice of the Right to Rescind, Pacific Shore had failed to include a date or deadline for which a notice of rescission must be delivered by the borrower and 2) Pacific Shore had failed to provide two copies of the consumer disclosures of the interest rate, monthly payments, and borrowers’ right not to complete the transaction, along with a notice that borrowers risked losing their home if they failed to keep current with their loan.*   

Pacific Shore did not dispute the TILA violations, instead admitting the violations had occurred but that as a matter of law, the borrowers had no loan to rescind.  At the lower court level, Pacific Shore was successful on a summary judgment motion with the court finding that since the Lozos had already refinanced their first loan, there was nothing left to rescind and following an earlier Ninth Circuit decision.  The matter went up on appeal, and the California Court of Appeal overturned the decision.

    On appeal, the Court declined to follow an earlier Ninth Circuit decision that went in favor of the lender.  The earlier decision in King v. State of California (1986) was a situation where the borrowers had been in bankruptcy, thus creating a transfer of the residence to the Trustee, effectively cutting off the borrower’s ability to rescind under TILA.  However, in the present case, the Lozos still held title to the property and the plain language of Regulation Z states “[i]f the required notice or material disclosures are not delivered, the right to rescind shall expire 3 years after consumer, [1] upon transfer of  all of the consumer’s interest in the property, or [2] upon sale of the property, whichever occurs first.”   

    Once the Court interpreted that the language Regulation Z did not address a refinance situation, the Court also went on to point out that even with a re-finance, the borrower was entitled to rescind and demand the interest, fees, penalties and charges paid. 

    The twist was that while the borrowers had three years to rescind the loan, they had only one year to seek damages for TILA violations.  The Lozos had waited nearly three years and so could not seek damages under TILA.  However, the borrowers also cross-complained under Business & Professions Code 17200, the UCL.  This provision provides separate relief for any acts that fall within the meaning of unfair competition as defined by the Code, and has a four-year statue of limitations.  The Court pointed out that while the borrowers could not seek money damages under the UCL, the borrowers may be entitled to disgorgement of any fees and penalties wrongfully obtained by the lender. 

    Most importantly, the UCL provides for injunctive relief to halt the deceptive advertising or practice being engaged in by the defendant.  The Court noted that Pacific Shore did not provide any evidence that it was unlikely to repeat the deceptive advertising or practices, thus subjecting them to a claim for injunctive relief from the borrowers.

    Ultimately, it did not matter whether or not the disclosures were intentionally left blank or intentionally withheld from borrowers.  Any violation of the disclosure requirements of TILA, even if the disclosure may have been substantially completed, was strictly construed against the lender and provided the borrower with a three year time frame to rescind the loan.  Furthermore, in conjunction with the relief sought under California’s Unfair Competition Law, the TILA violation gave rise to another claim for relief to the borrowers.

    In reading the decision, it was evident that the Appellate Court looked at Pacific Shore Lending and found the surrounding circumstances between the lender and borrower inequitable, noting that TILA was designed to protect against “unscrupulous lenders with a means of laundering their TILA violations in the initial loan by refinancing it with a second loan, while forever preventing borrowers from recouping their wrongfully paid finance charges, downpayments and other fees.”  Clearly, no lender wants to be grouped in that category with Pacific Shore Lending.

    The lesson to take away for lenders making high cost loans is that errors or omissions on disclosures can be costly.   A blank on the disclosure can be as fatal as not providing the disclosure at all.  In the close relationship between the broker and the lender and in some cases, the escrow officer, it may be tempting to pass the buck on whose responsibility it is to get the loan documents and disclosures to the borrowers.  However, there is no substitute for a thorough review.  Furthermore, if a demand for rescission is made by a borrower, that is not a time to play hardball with them.  Pull the files and engage an outside professional to comb through the documents for any possible omissions or defects in the documentation.  Compromising with the borrower prior to litigation is a far less costly solution. 

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* Actually, it is unclear from the case decision, but may be possible that Pacific Shore did actually supply the disclosures, but either neglected to supply two copies to the borrowers or neglected to supply the disclosures within the required three days prior to the execution of the loan documents.

 

California's New Loan Modification Laws and Suspended Lawyers

Our governor signed S.B. 94, and so now everyone is prohibited from taking "advance" fees to assist with a loan modification for a borrower.  This prohibition includes attorneys and causes some change in law firm practices. 

Normally, when a borrower is coming to an attorney with a loan problem, it is likely because the borrower lacks funds to pay the lender.  It also means they may lack funds to pay the law firm.  Accordingly, to minimize collection issues, many law firms would ask for a retainer and place the funds into the client trust account (which is technically the client's money until earned) and refund the balance if there is a surplus when ther matter is concluded.

However, this new law seems to simply revert law firms to the normal model of invoicing the client regularly as the lawyer's time is billed and then having to wait and hope the client will pay it.

While this is causing a lot of concern, especially knowing that many law firms will decide against doing any loan modification work at all, the abuses were so widespread, it seemed a draconian legislative response was called for.

Because Realtors^TM are prohibited by the California Department of Real Estate from collecting advance fees, they were bringing in attorneys to circumvent this rule because attorneys were allowed to collect fees in advance by the State Bar.  However, attorneys are prohibited from fee splitting with unlicensed persons and so this whole model was problematic.

Just this week, the State Bar announced the suspension of yet MORE lawyers caught up in the unethical practices of loan modification mills. 

"The State Bar created a 10-person loan modification task force in March after receiving thousands of calls from homeowners complaining that lawyers have done no work after taking fees purportedly to help avoid foreclosure. The task force had 738 active investigations underway last month."

California Foreclosure Consultants Now Must Register

After July 1, 2009, it became illegal to act as a Foreclosure Consultant in the State of California unless you registered first with the Attorney General. 

In addition to the $850 filing fee and the application and a copy of the contract you will use with your clients, you must be bonded at a minimum of $100,000.00 and register that bond with the California Secretary of State.

What is a "foreclosure consultant" as defined by California Law?
(California Civil Code 2945.1, "Mortgage Foreclosure Consultant Law")

The following definitions apply to this chapter:
 (a) "Foreclosure consultant" means any person who makes any
solicitation, representation, or offer to any owner to perform for
compensation or who, for compensation, performs any service which the
person in any manner represents will in any manner do any of the
following:
 (1) Stop or postpone the foreclosure sale.
 (2) Obtain any forbearance from any beneficiary or mortgagee.
 (3) Assist the owner to exercise the right of reinstatement
provided in Section 2924c.
 (4) Obtain any extension of the period within which the owner may
reinstate his or her obligation.
 (5) Obtain any waiver of an acceleration clause contained in any
promissory note or contract secured by a deed of trust or mortgage on
a residence in foreclosure or contained that deed of trust or
mortgage.
 (6) Assist the owner to obtain a loan or advance of funds.
 (7) Avoid or ameliorate the impairment of the owner's credit
resulting from the recording of a notice of default or the conduct of
a foreclosure sale.
 (8) Save the owner's residence from foreclosure.
 (9) Assist the owner in obtaining from the beneficiary, mortgagee,
trustee under a power of sale, or counsel for the beneficiary,
mortgagee, or trustee, the remaining proceeds from the foreclosure
sale of the owner's residence.

Loan Modification Failure Rate - 24% in 2 months.

as reported by the United States Office of Thrift Supervision, within six months after modification:

•  24% of the mortgages that had monthly payments reduced by 20 percent or more were 60 or more days past due versus
• 54% of mortgages with monthly payments if no loan mod.

See the June 30, 2009 quarterly report. 

This report went on to say, "Foreclosures in process increased.  Foreclosures in process also increased during the quarter to 844,389, or about 2.5 percent of all serviced loans, as moratoriums on foreclosures expired during the first quarter.  This increase represented a 22 percent jump from the previous quarter and a 73 percent rise from the first quarter of 2008."

So, despite an increasing number of loan mods offered, one in four of those borrowers still default within 2 months and we have a 73% jump in foreclosures compared to last year.

Does this sound to you like loan mods are working? I'm not convinced.  Nor am I convinced that we have hit the bottom of the residential cycle yet due to all this inventory in the foreclosure pipeline. 

Why aren't loan mods working? Human nature.  If you have a mortgage of $500k on your house in San Jose, California and your house is now worth $400k, are you going to keep paying your new lower interest payment?

Loan mods only modify the interest, not the principal.  Legislators should not modify the principals on these loans either because that would penalize the rest of the U.S. homeowners (over 90%) who pay their mortgages on time, borrowed what they could afford and should not be seeing their neighbor who put zero down and cashed out to buy a BMW get a lower principal on his or her mortgage.

Mortgage Fraudsters Sentenced to 23 Years.

It took a long time, but after years of both criminal and civil litigation, the criminal case is finally coming to a close.

"Santa Clara County Superior Court Judge Vincent Chiarello sentenced Esperanza Valverde, 41, to 23 years and 8 months, and her husband, Herman Covarrubias, also 41, to 19 years and 8 months in prison. The couple was ordered to pay more than $900,000 in restitution to victims."

Full text here.

Among other dirty deeds, the shop that Covarrubias was running, Summit Mortgage (out of Milpitas) was accused to have supplied lenders with false tax returns, W-2 statements, pay stubs and employment verification letters.

It's no secret that underwriting over the years has been sloppy during the good times, but even the most lenient mortgage brokers shied away from outright forgery. 

The borrowers defaulted on the outrageous loans and some lost their homes.  How did the lenders fare?

"The banks were BNC Mortgage, which was shut down by Lehman Brothers before Lehman collapsed last year; Argent Mortgage and World Savings, which were acquired by other companies; GE's WMC Mortgage, which shut down in 2007; and Downey Savings, which was seized by regulators last year."

Having seen some of the loan docs, the question in my mind is what did the lenders think when they received a loan application where a blue-collar worker had a 6-figure salary?  I am not blaming the lenders for being defrauded, but I do think better safeguards should have been in place on the lender side as well.

Guaranty, Guarantee, Potato, Potahto…

For many private money investors (or hard money lenders as they are sometimes referred to), a loan to an LLC alone carries too many risks.  Accordingly, a personal guarantee from the managing member or other members of the LLC with collateral will be required.

 

Since the underlying loan obligation to the LLC was secured by a deed of trust against real estate—and the real estate values have plummeted, we are seeing a rise in the number of lawsuits by lenders against guarantors to enforce of the guarantee agreements.

How do California’s anti-deficiency provisions protect guarantors?  They don’t.  Well, not exactly.

In the seminal case of Union Bank v. Gradsky, the court first enumerated the Gradsky doctrine and found that while the legislature did not intend for anti-deficiency statutes (California Code of Civil Procedure Sections 580(b) and 580(d)) to protect guarantors, that the doctrine of estoppel prevented lenders from going after the guarantor once the lender had already foreclosed on the collateral.*

 

The reasoning was that once a guarantor pays the debt of another, the guarantor assumes the rights of the lender/creditor and should be entitled to pursue the borrower to recover the losses.  Accordingly, if the lender has already foreclosed on the collateral, they have prevented the guarantor from going after the collateral and harmed the guarantor by altering the position of the parties from the time of the bargained for guarantee.

 

Accordingly, most savvy transactional lawyers who draft guarantees will include contractual Gradsky waivers as enumerated by Civil Code Section 2856 which states:

 

§ 2856. Waiver of suretyship rights and defenses; contract language; effectiveness; applicability; validity of waivers executed prior to January 1, 1997

(a) Any guarantor or other surety, including a guarantor of a note or other obligation secured by real property or an estate for years, may waive any or all of the following:

(1) The guarantor or other surety's rights of subrogation, reimbursement, indemnification, and contribution and any other rights and defenses that are or may become available to the guarantor or other surety by reason of Sections 2787 to 2855, inclusive.

(2) Any rights or defenses the guarantor or other surety may have in respect of his or her obligations as a guarantor or other surety by reason of any election of remedies by the creditor.

(3) Any rights or defenses the guarantor or other surety may have because the principal's note or other obligation is secured by real property or an estate for years. These rights or defenses include, but are not limited to, any rights or defenses that are based upon, directly or indirectly, the application of Section 580a, 580b, 580d, or 726 of the Code of Civil Procedure to the principal's note or other obligation.

(b) A contractual provision that expresses an intent to waive any or all of the rights and defenses described in subdivision (a) shall be effective to waive these rights and defenses without regard to the inclusion of any particular language or phrases in the contract to waive any rights and defenses or any references to statutory provisions or judicial decisions.

(c) Without limiting any rights of the creditor or any guarantor or other surety to use any other language to express an intent to waive any or all of the rights and defenses described in paragraphs (2) and (3) of subdivision (a), the following provisions in a contract shall effectively waive all rights and defenses described in paragraphs (2) and (3) of subdivision (a):

The guarantor waives all rights and defenses that the guarantor may have because the debtor's debt is secured by real property. This means, among other things:

(1) The creditor may collect from the guarantor without first foreclosing on any real or personal property collateral pledged by the debtor.

(2) If the creditor forecloses on any real property collateral pledged by the debtor:

(A) The amount of the debt may be reduced only by the price for which that collateral is sold at the foreclosure sale, even if the collateral is worth more than the sale price.

(B) The creditor may collect from the guarantor even if the creditor, by foreclosing on the real property collateral, has destroyed any right the guarantor may have to collect from the debtor.

This is an unconditional and irrevocable waiver of any rights and defenses the guarantor may have because the debtor's debt is secured by real property. These rights and defenses include, but are not limited to, any rights or defenses based upon Section 580a, 580b, 580d, or 726 of the Code of Civil Procedure.

(d) Without limiting any rights of the creditor or any guarantor or other surety to use any other language to express an intent to waive all rights and defenses of the surety by reason of any election of remedies by the creditor, the following provision shall be effective to waive all rights and defenses the guarantor or other surety may have in respect of his or her obligations as a surety by reason of an election of remedies by the creditor:

The guarantor waives all rights and defenses arising out of an election of remedies by the creditor, even though that election of remedies, such as a nonjudicial foreclosure with respect to security for a guaranteed obligation, has destroyed the guarantor's rights of subrogation and reimbursement against the principal by the operation of Section 580d of the Code of Civil Procedure or otherwise.

(e) Subdivisions (b), (c), and (d) shall not apply to a guaranty or other type of suretyship obligation made in respect of a loan secured by a deed of trust or mortgage on a dwelling for not more than four families when the dwelling is occupied, entirely or in part, by the borrower and that loan was in fact used to pay all or part of the purchase price of that dwelling.

(f) The validity of a waiver executed before January 1, 1997, shall be determined by the application of the law that existed on the date that the waiver was executed.

 

A lender has a few choices when they are faced with going after collateral with declining value and a loan guarantee.  The lender can 1) conduct a non-judicial foreclosure and walk away from the guarantee; or 2) conduct a judicial foreclosure and sweep in the guarantee claims and name both the borrower and the guarantor; or 3) go after the guarantor for the entire amount owed.

 

Additionally, if the guarantee contains all the necessary waivers, the lender can both non-judicially foreclose on the collateral and go after the guarantor for the deficiency owed.

 

*The court also reiterated that the “one-action rule” (C.C.P. §726) did not apply to  guarantees.   

Private Money Investors Beware

Here in Northern California, we are all just wrapping up the mess that California Plan, Inc. made.  Michael Schneider was convicted and only recently sentenced.  He stole over $40M from investors, and was sentenced to 28 years.  Schneider's fraud was typical in that all investors claimed Schneider had their trust and was like family to them. 

Now the Cedar Funding fiasco in Monterey has surfaced.  Cedar Funding is a $70M+ fund, and the principal, David Nilsen, has been accused of running a giant Ponzi scheme, loaning money to insiders, (ie, himself to purchase his $4.2M posh home).  The DRE has suspended his license.  The Court has appointed a receiver to manage the fund and the DA is investigating.  Again, investors are saying that they trusted Nilsen.  The Montery Herald article says it all:

Nilsen was a member of her church, she said, and he instilled her with a sense of trust.

"I thought, 'This man is a God-fearing individual who would take good care of my money,'" said Abraham-North. "But he did not — he left me penniless."

The schemes fraudsters like Schneider use are not particularly creative.  Schneider was simply cutting and pasting investor names onto a Deed of Trust to make it look like it had been recorded for the investor.  In reality, Schneider photocopied investor names and glued them over the actual secured parties' name.  In this manner, he was able to make it look like the investor was secured when in fact, the Deed of Trust with their name was forged.

Additionally Schneider would not tell investors when their loans had paid off.  Instead, investors received their monthly interest payments for years, never realizing the borrower had re-financed and paid off their loan years ago.  Often, Schneider would tell investors after a payoff to leave their money in his trust account and he would "roll it over" into the next loan to allow them to continue to earn interest on their money.

How does an investor protect his or herself from this? 

Regardless of how trustworthy and conscientious a broker is, the investor must safeguard their financial future and take charge of their loan portfolio. If the investors had simply asked Schneider for the originals of their Deed of Trust, half their problem would have been eliminated. 

Additionally, a random spot check/audit of your Deed of Trust investing portfolio is never a bad idea.  You can search county records to see if your Deed of Trust has been reconveyed.  If it has, but you never received the payoff funds--you've got a problem.

Lastly, complacency puts the investor at risk.  If your loan pays off--take the money.  Wait for your broker to bring you the next investment opportunity and re-invest your money.  Losing out on a month of interest can spare the investor the heartache of losing the whole enchilada.

For investors in mortgage pools or collateralized mortgage obligations--you are entitled to monthly accountings.  If you are uncomfortable about not knowing the percentage loans held by insiders, hire an independent auditor to help you ask the right questions and get the right documentation from the fund manager.

New Foreclosure Related Legislation

DISCLAIMER: THIS IS NOT INTENDED TO BE TAX ADVICE. FOR TAX ADVICE FOR YOUR SPECIFIC SITUATION, CONSULT WITH A TAX PROFESSIONAL. 

Though my work is lender focused, I frequently receive calls and emails from borrowers who want to know if they can just "walk away" from their loans.

From my previous posts, it is obvious that I work for lenders pursuing judicial foreclosures and deficiency judgments.  (See previous blog entries regarding California's One Action Rule and Anti-Deficiency statutes).  That means that while I can quote verbatim from the statute about which loans are recourse, that does not mean that I know anything about the specific tax consequences. 

In addition to the possibility of a deficiency judgment, the borrowers who cannot meet their loan committments could have tax consequences. 

Generally in short sale situations, the debt remaining is treated as a debt forgiveness--which creates income.  The most interesting piece of new legislation I've seen is the Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648) which snuck in quietly in late 2007.

If the borrower meets certain criteria, the debt cancelled will not be treated as income for federal income tax purposes.  This act applies to income in 2007, 2008 and 2009.  The catch?

That doesn't solve the state tax consequence.  Since California has not passed a companion law yet, the California Franchise Tax Board likely takes a different view of the situation. 

That might change for next year, but in the meantime--borrowers who are paying to sign up for these "homeowner walk away" from their mortgage should beware.  There is no one size fits all solution.  No one can predict how a lender will choose to deal with a bad loan, or the likelihood the lender will pursue a judicial foreclosure and seek a deficiency judgment.