Important Tax Considerations in Foreclosures, Short Sales, and Deeds-in-Lieu of Foreclosure

By Yulissa Zulaica

How do you determine capital gains?

Capital Gains or losses = Amount Realized (AR) – Adjusted Basis (AB)

How do you determine whether there is income from cancellation of debt from a foreclosure, deed in lieu of foreclosure or short sale?

Cancellation of debt (COD) income is defined as the amount by which the canceled debt is more than the fair market value of the property which was used to secure the loan. COD income can occur when a bank forgives part of a debt to which a person was personally liable.

Exceptions to Cancellation of Debt Income: Insolvency Bankruptcy Mortgage Debt Forgiveness Act of 2007 Certain farm debts Non-Recourse Loans

Primary Residence versus Investment property: Capital losses resulting from the sale of a primary residence are not deductible. However, a person may still incur capital gains on the sale of her/his primary residence if the amount realized was greater than the person’s adjusted basis. It is important to note, however, that there is a $250,000 capital gain exclusion which a person may elect to apply. In order to qualify for this exclusion they must have lived in the home for 2 years over the last 5 years, which does not have to be consecutive, and the home must be the person’s primary residence.

Capital losses resulting from the sale of an investment property on the other hand, are deductible against capital gains, if they are available. Generally, capital losses may be applied towards ordinary income, but only up to a maximum of $3,000 per year ($1,500 if married filing separately) and the remaining capital losses may be carried forward. However, when dealing with rental property, by definition, all rental activities are considered passive and passive activity gain and loss are treated differently. Generally, passive activity gains and losses are netted against each other. If the passive activity income exceeds the available passive activity loss then it is income to the taxpayer. If the passive activity loss exceeds the income then the losses that exceed the available income will be suspended and carried forward until there is passive activity income to offset said loss. Additional limitations to this rule exists which depend on the taxpayer’s adjusted gross income and/or level of participation.

In sum, a person seriously considering a foreclosure, deed in lieu of foreclosure and/or short sale should discuss the potential tax consequences of a specific transaction with a tax attorney and/or accountant.

Recourse Loans versus Non-Recourse Loans: A recourse loan is a loan in which the borrower may be personally liable. A non-recourse loan is a loan which is usually secured by collateral and in which a borrower may not be held personally liable if the collateral does not satisfy the full value of the amount owed.

In a recourse loan, the Amount Realized (AR) is the canceled debt up to the fair market value of the property. In a non-recourse loan, the AR is the full amount of the debt. The gain or loss in either type of loan is calculated by subtracting the adjusted basis from the amount realized. To see why it is important to determine the type of loan and the type of property, see examples below.

Example 1:

Non-Recourse Loan

Facts: A buys a condo for $200,000. A puts $15,000 down and obtains a loan of $185,000.

The bank foreclosed on the loan and at that time the vale of loan was $180,000. Fair market value of the property was $170,000. A’s adjusted basis in the property was $175,000 (due to casualty loss she had deducted).

Results: A has a $5,000 gain, the amount by which A’s adjusted basis in the condo exceeds its fair market value. Whether or not it is a taxable gain will depend on whether A qualifies for and elects to use part of the capital gains exclusion amount.

There is no income from cancellation of debt for non-recourse debt.

Example 2: Recourse Loan

Facts: Same as above.

Results: A has a $5,000 capital loss, the amount by which A’s amount realized, which is equal to the property’s fair market value, exceeds A’s adjusted basis in the condo, and a $10,000 or ordinary income derived from the debt cancellation. The income is derived from subtracting the amount realized ($170,000) from the total amount of the debt ($180,000).

A cannot deduct the capital losses if the condo is her or his primary residence. If it is an investment property, however, A can use capital gains to offset capital losses subject to the loss limitations discussed above.

Prenuptial/Pre-Registration Agreements: Are They Right for You?

While a prenuptial agreement cannot limit your obligations of mutual respect, fidelity, and support, nor do away with your duty to deal with your spouse with the highest good faith and fair dealing under California law, it can be a useful tool to define your property rights during the marriage/partnership, as well as confirm the separate character of the property holdings you bring into the marriage.

While we tailor each agreement to the particular needs of our clients, here are some of the main issues that we address in our prenuptial agreements:

(1)  Defining your assets before marriage:  each partner may bring assets into the marriage that they want to confirm as their sole and separate property.  California law dictates that property you bring into the marriage remains your separate property, but complete disclosure with your partner from the outset can avoid waste of time and expense should the marriage breakdown.  In every prenuptial agreement, we require a complete disclosure and exchange of both parties’ lists of current assets and liabilities.  The agreement will confirm what is and what should remain as your sole and separate property.

(2)  Defining your assets during marriage: under California law, during registration/marriage, both of your earned incomes and/or jointly acquired assets from that income are community property.  The characterization as community property has special repercussions particularly upon divorce or death.  Upon divorce, your community property will be divided 50/50 between you and your ex-partner; and at death, absent any estate planning, the entirety of your community property passes to your partner upon your death.  A prenuptial agreement, however, can define whether or not you intend to create any community property during your partnership.  You may choose, with your partner, to keep your income, business interests, and retirement accounts, for example, completely separate.  Or, you may choose to have your salaries remain community property, but allow for contributions to your retirement accounts that you intend to be separate property.  A prenuptial agreement can allow flexibility in determining property characterization, and perhaps most importantly, it can set clear guidelines to make any dissolution proceedings simpler.

(3)  Rights to reimbursement: following from numbers (1) and (2), above, prenuptial agreements can also determine whether a partner has a right to reimbursement to any contributions they made throughout the marriage.  For example, if you purchase a house before the marriage with your separate property, but your partner contributes their separate property toward a major renovation of the house, or you are both paying the mortgage with your community property, you can determine, through your prenuptial agreement, what rights, if any, you or your partner has to reimbursement of the amount spent toward the costs of improvement and any appreciation in the value of the house as a result.  California law permits reimbursements of separate and community property, but a prenuptial agreement may contemplate specific probable situations for you and your spouse.

(4)  Spousal support: Under California law, there are numerous factors that a court will consider when determining whether to grant a partner alimony.  Many couples do not like putting their fate in the hands of a third party, and so they draft prenuptial agreements to allow themselves to determine an equitable way to approach spousal support.  Spouses/partners may choose to waive spousal support, provide a lump sum payment to a spouse with less earning potential, or even base any amount paid on the number of years they are married.  Drafting a spousal support provision in a prenuptial agreement is not mandatory, but it is another way that the parties can craft their own property division should their partnership dissolve.

(5)  Child support: whether you have children before marriage or during, a prenuptial agreement cannot serve as a waiver, or determine rights, to child support.  Child support obligations are set by state law, and it is against public policy for spouses to agree to any limits on child support payments.

(6)  Taxes: parties to a prenuptial agreement may also agree to file joint tax returns, even if they agreed to keep all their property separate during marriage.

(7)  Commingling of assets: in reality, during marriage, keeping your assets separate is never black and white.  A prenuptial agreement can serve as a roadmap in a situation where there was unintentional commingling of assets.  For instance, you may inadvertently put separate property money into a joint account or invest separate property in a community asset.  These are, of course, common situations, and your prenuptial agreement can help guide you and your spouse if you sell a commingle asset during marriage, or if you are determining the character of the property on divorce.

(8)  Other provisions: characterization of assets is the primary reason most couples want a prenuptial agreement, but an agreement between spouses can also provide details on, among other things, the character of any debt incurred during the marriage; the division of business interests acquired before and during marriage; and guidance over living and housing expenses.

A prenuptial agreement may not be in everyone’s interest, but, as you can see, it may be a useful tool for couples that recognize their fiduciary duties to each other, but want to craft their own agreement to suit their particular living situation.

Real Estate Titling for Same-Sex Couples in California

For most heterosexual couples, the question of their legal status in California or elsewhere is generally a simple one – they are either married or single.[1] Under the current legal framework in California, the answer is not as clear for same-sex couples, because there are five distinct legal statuses that a same-sex couple may hold. Furthermore, if a heterosexual married couple residing in California purchases real property, it is generally understood among titling professionals that the couple can hold title to the subject property as community property with right of survivorship, community, or separate property, in joint tenancy, or as tenants in common. Unfortunately, it is becoming clear that many professionals who work on titling real property assets for same-sex couples do not understand that the same rules apply to same-sex couples that hold title to property in California, so long as the couple is in a legally recognized relationship, irrespective of its title. This can often lead even the most well-intentioned professionals to incorrectly title real estate and other assets held by same-sex couples.

Status Options for Same-Sex Couples

Under current California law, there are five distinct statuses recognizing legally related same-sex couples, each of which depends in large part on the date and location of the couple’s registration or marriage. These statuses are: Registered Domestic Partners; married; Registered Domestic Partners and married; “married equivalent”; and Registered Domestic Partners and “married equivalent.”

Registered Domestic Partners
One of the most common statuses for Californian same-sex couples is that of Registered Domestic Partners (RDPs). This status applies to any couple who registered with the State of California on or after January 1, 2000 and who did not “opt out” of the RDP status before January 1, 2005 when AB 205, the California Domestic Partners Rights and Responsibilities Act of 2003, became effective, or whose members have not formally dissolved their relationship.

Pursuant to California Family Code Section 299.2, this title also applies to those same-sex couples who entered into a legally recognized relationship in a foreign jurisdiction, whether elsewhere in the United States or in another country, that is “substantially equivalent” to a California domestic partnership.  Such “substantially equivalent” relationships include the marriages, civil unions or comprehensive domestic partnerships provided by state law in some states, such as Massachusetts or New York. However, the limited rights granted to same-sex couples in other states, such as Colorado, Maine, Maryland, or Wisconsin, are not characterized as “substantially equivalent” and, as a result, a couple who has registered in one of those states but has not subsequently registered with the State of California would not be deemed RDPs under California law.

The second status, which applies to those approximately 18,000 same-sex couples that were married in California between June 16 and November 4, 2008, is “married.” As a result of the In re Marriage Cases decision of 2008, where the California Supreme Court recognized the state constitutional right of same-sex couples to marry, this title is also applicable to those same-sex couples who were validly married in a foreign jurisdiction, whether in the United States or in another country, on or before November 4, 2008.

Registered Domestic Partner and Married
The third option, which is quite common for those whose marriages are recognized by the State of California as set forth above, is “RDP and married.” Because California law allowed RDPs to marry without first dissolving the registered domestic partnership, many couples who had previously registered with the State as domestic partners subsequently married and, as a result, now hold both statuses.

“Married Equivalent”
The next status is more difficult to name. SB 54, which went into effect January 1, 2010, said, in part, that couples who have been legally married in a foreign jurisdiction on or after November 5, 2008 are entitled to all the rights, benefits, and obligations of marriage, except they may not use the term “marriage” to describe their relationship. The latter part of this language is what makes this last option difficult to name. If a couple has been legally married outside of California after November 5, 2008, and has not also registered as domestic partners in California, then they cannot be called RDPs, but they are also precluded from being called “married.”  So, you may ask, what are we to call couples that fall in to this category? Although there is no definite answer to this question, “married equivalent” is an accurate description, as is “spouses” or “spouses under the laws of [name of the officiating jurisdiction].”

Registered Domestic Partners and “Married Equivalent”
Finally, it is possible for those “married equivalent” couples to register as domestic partners with the State of California. In that case, both titles would be applicable.

This is complex and can be very confusing, both for professionals working with same-sex couples and, not surprisingly, for same-sex couples themselves.  It is precisely because of this potential confusion that professionals who work on titling real estate and other assets owned by same-sex couples must be particularly intent on making sure that they talk freely with their clients and ask as many questions as necessary to ensure that they have all of the information they need to properly identify the status of the couple on the titling documents.

Property Characterization

Once the actual legal status of clients is determined, the second, and most significant, issue is to ensure that the subject property is characterized properly in the title documents. Because RDPs, married same-sex couples, and “married equivalent” couples are entitled to all of the same rights and subject to all of the same responsibilities as heterosexual married couples under California law, they are subject to California’s community property regime. This means that there is a presumption that if such a couple acquires property during the tenure of their legally recognized relationship, the property is community property. Therefore, just as heterosexual spouses can hold property as community property with right of survivorship, community, or separate property, in joint tenancy, or as tenants in common, so, too, can same-sex couples.

It is especially important that the intended ownership of real property is properly identified on the original title because, although under California law a transfer of real property between RDPs or same-sex spouses does not constitute a change of ownership that would trigger a reassessment, same-sex couples do not enjoy federal recognition. As a result, same-sex couples do not have the option of making unlimited transfers between themselves without the potential of those transfers being characterized as taxable transfers by the IRS. This means that if title is taken incorrectly in the original title and must later be corrected to reflect the intended ownership of the property, there is a chance that this latter “change in ownership” will have negative tax consequences for the affected couple. In addition, at the death of the first partner or spouse, the survivor is entitled to a full step up in the basis of the property for purposes of California law if the property is owned as community property with the right of survivorship or community property, but not for separate property, joint tenancy property, or property held as tenants in common. Improperly titled property may ultimately create a significant capital gains issue for the survivor.

If property is incorrectly titled, it is also possible that the incorrect titling could lead to a situation where, upon the death of one partner or spouse, the survivor could lose control over the decedent’s one-half of the property. When there are hostile family members involved, this could result in the survivor’s being unable to retain ownership of the property.

Although the laws have changed significantly in recent years, and are likely to continue changing in the future, it is imperative to insure that real property assets are titled correctly. The existing legal framework does require that the professionals involved with the transfer and titling of those assets be educated, understand the issues, talk freely with their clients to ensure that they have all of the necessary information to properly title an asset, and know what resources are available for both the professionals and their clients in the event that questions arise that cannot be answered by the titling professional or the client. It is also important for the owners of real property to assert their rights when taking title. Because of the lack of federal recognition for tax purposes, each situation is different and the particular circumstances should be fully considered prior to vesting. Please call the offices should you have questions, and also see “IRS Recognizes Community Property Law in California for Registered Domestic Partners” for more information on this issue.

Ways Forward

In light of the current legal framework and the significant issues associated with titling, we recommend the following language for use in titling documents:

For RDPs:  “Jane Smith and Sally Jones, Registered Domestic Partners, as [community property with right of survivorship/community property/separate property/joint tenants/tenants in common]”

For married same-sex couples:  “Jane Smith and Sally Jones, spouses, as [community property with right of survivorship/community property/separate property/joint tenants/tenants in common]”

For RDPs and married same-sex couples: “Jane Smith and Sally Jones, spouses and Registered Domestic Partners, as [community property with right of survivorship/community property/separate property/joint tenants/tenants in common]”

For “married equivalent” same-sex couples: “Jane Smith and Sally Jones, spouses under the laws of [Name of the jurisdiction], as [community property with right of survivorship/community property/separate property/joint tenants/tenants in common]”

For RDPs and “married equivalent” same-sex couples: “Jane Smith and Sally Jones, spouses under the laws of [Name of the jurisdiction] and Registered Domestic Partners, as [community property with right of survivorship/community property/separate property/joint tenants/tenants in common]”

[1] California Family Code Section 297(b)(5)(B) permits opposite sex couples to register as domestic partners if at least one of the parties is at least 62 years old and eligible for Social Security benefits.