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Many Florida real estate investors are concerned about personal liability from mortgage foreclosure deficiency judgments. Although they accept loss of equity, if any, in property which is foreclosed by their mortgage lender, people are afraid of a deficiency judgment. A deficiency judgment refers to a mortgage lender’s judgment against the borrower for the difference between the outstanding balance of the mortgage note, plus costs and attorneys fees, and the value of the property foreclosed. The property value is determined on the date of the foreclosure sale.
In Florida, a mortgage foreclosure does not automatically result in a deficiency judgment. Just because you lose a property at foreclosure does not mean you will remain personally liable for money owed to the lender . To obtain a deficiency judgment against the borrower the foreclosure sale the mortgage lender has to file a motion for a deficiency after the foreclosure sale, and the court must hold a separate evidentiary hearing on the lender’s request for deficiency liability. At the evidentiary hearing the mortgage lender has to show the court evidence that the property’s value on the sale date was less than the note balance. The borrower can get his own appraisal or can use the government's tax assessed value as evidence of value. If the property was worth more than note balance on sale date the court will not give the mortgage lender a deficiency judgment against the borrower. The borrower may present evidence of value in the form of a formal appraisal or other less formal opinions of value such as the local government's tax assessed value.
During the recent real estate boom deficiency judgments were uncommon because increasing real estate values brought home values above note balances of defaulting mortgages. Additionally, lenders could take back "upside down" properties and hold them until the rising market made them whole. Up to this point in the real estate crash few mortgage service companies with conventional mortgages have been pursuing deficienty judgments, especially mortgages on owner occupied homes. Second mortgage lenders and private lenders are more likely than first mortgage holders to go after deficiency judgments. Banks that made commercial loans to developers or builders almost always file a lawsuit against the individual borrower to enforce the promissory note. As the real estate recession worsens more conventional mortgage lenders may pursue deficiency judgments. If a mortgage lender pursues a deficiency judgment you should hire an attorney to defend the deficiency. In many cases, an attorney can use procedural defenses and substantive lending law to defeat a deficiency claim, and the attorney can negotiate an acceptable settlement for much less than the total deficiency liability in most cases.
Another problem with mortgage foreclosure is possible income tax consequences. The general rule is that when a lender forgives or cancels a debt the borrower can incur income tax on the amount of debt forgiveness. When you arrange a discount in your mortgage in order to sell house (a so-called "short sale") the mortgage lender will cancel part of your mortgage debt and you will receive a tax form 1099 telling the IRS that you have imputed income for the amount of debt reduction. You will also incur income tax liability for a deed in lieu of foreclosure. The taxable income will be the difference between the property value and the balance of the mortgage loan on the date you surrender the property to the bank.
A foreclosure may result in cancellation of debt income depending on whether the bank pursues a deficiency judgment. If the mortgage lender gets a deficiency judgment for the difference between the property value on foreclosure sale date and the mortgage balance the lender is not forgiving any part of the loan. If the bank chooses not to pursue a deficiency judgment, or pursues the judgment unsuccessfully, the borrower may incur income tax liability for debt foregiveness.
In December, 2007, Congress acted to protect many debtors from income tax liability associated with foreclosure avoidance. The Mortgage Forgiveness Debt Relief Act of 2007 states that homeowners will not be subject to income tax from release from mortgage liability if and to the extent the mortgage proceeds were used to buy or improve their primary residence. There is no income tax shelter from foregiveness of mortgage debts for investment property, vacation homes, or mortgages used for businesses or to pay off credit card balances. The protection expires in December, 2009. You should speak with an attorney or CPA familiier with the new law to see if you qualify for income tax protection.
For those borrowers who do not qualify for protection of the new Act there is an insolvency exception to imputed income from the cancellation of mortgage debt. If a borrower is financially insolvent when he surrenders the mortgaged property to the lender voluntarily or through foreclosure there will be no imputed income. A borrower who files bankruptcy is presumed to be insolvent, so that a bankruptcy debtor cannot suffer imputed income tax liability because the bankruptcy discharges personal liability under a mortgage note. More information is available from IRS Publication 908 and IRS tax form 982. Both forms can be found at irs.gov.
The tax law permits many real estate investors to offset imputed debt foregiveness income with corresponding tax losses. For example, if a lender forecloses on a parcel of income producing rental property you may be able to report a capital loss to offset all of your imputed income from debt foregiveness in the same year you receive a 1099 from the mortgage lender. When your foreclosed property was not income producing but was held solely for future appreciation, your capital losses may be limited to $3,000 per year so that the total loss will have to be amortized over many future tax years. You should consult your CPA to determine the tax impact of a mortgage foreclosure on your tax situation. The tax impact of foreclosure is not a legal issue.