Refi loans could prove costly in foreclosure
Law allows lenders to go after personal savings as well as the house, unlike original mortgage.
The Orange County Register
WORD OF ADVICE: "This is going to become a hot topic," says Bradford L. Hall, managing director of Hall & Co. in Irvine, of recourse loans.
Homeowners behind in their mortgage payments after hocking the house to pay for a major remodel or a new boat or car may be in for a rude awakening.
If they previously refinanced and their lender decides to foreclose, they may not only lose their house, but the bank also may be able to go after their other financial assets including stocks, savings and their paycheck.
And even if the bank doesn't go after their other assets, a foreclosure may mean a big tax bill from the IRS and state Franchise Tax Board for any shortfall between what the bank gets for the sale of the owner's home and the value of the loan.
"This is going to become a hot topic," predicts Bradford L. Hall, managing director of Hall & Co., CPAs in Irvine, who remembers the pain of foreclosures during the 1990s. "There's very little awareness of what can happen when you can't make your payments and are forced to sell your home for less than the mortgage balance or lose your home through foreclosure."
Foreclosure hasn't been a major issue in Orange County for a decade as homeowners in recent years enjoyed low interest rates and double- digit price appreciation.
Rather than a place to live, houses increasingly were seen as another source of money. Refinancing became the norm as owners cashed in on their newfound equity for such things as home remodels and expensive toys.
But now as interest rates rise, home sales slow and price increases moderate, people who depended on always being able to refinance are finding themselves not only tapped out but falling behind.
Trouble ahead
Signs of trouble ahead are just beginning to appear. Lenders only sent out 444 local default notices in May, the most recent figures available, but that was 57 percent more than May of last year, according to DataQuick, the real estate information company. Foreclosures ticked up to 37 in May from an average of 25 a month.
Those figures don't even come close to the record 2,320 default notices and 674 foreclosures DataQuick recorded at the peak of the last downturn in the fall of 1996. But as thousands of adjustable loans adjust to higher – sometimes significantly higher – rates over the next two years, the situation is expected to get worse.
In a study released in February, First American Real Estate Solutions in Santa Ana estimated as many as 8,000 Orange County homeowners could lose their homes to foreclosure over the next four years.
Some homeowners with little of their own money in their homes may think they will do what strapped homeowners in the '90s did: turn over the keys to their lender if things get really bad and walk away.
But Hall and other financial experts warn that things may be different this time because so many people have refinanced. The difference is the recourse loan.
In the past, when a lender foreclosed, the homeowner usually still had the original loan they got when they purchased the house. Original loans, considered purchase money, are non-recourse loans that limit lenders to recovering only what they can get when they sell the house. They can't go after the owner to pay any difference between the foreclosure sales price and the loan balance.
But in California, refinanced loans, second trust deeds and home equity lines of credit are generally considered recourse loans. In these cases, a lender can file suit and go after almost any of the borrower's assets once they obtain a court judgment.
"They can literally go after everything you have," Hall says.
There are a few limited exceptions. Retirement accounts are excluded, and declaring bankruptcy could protect some homeowners.
In the past, lenders have been reluctant to go after borrowers personally because it takes time and can involve costly litigation, but Hall says things might be different this time, especially if a borrower has substantial assets.
The tax man
Even if a lender doesn't go after a homeowner's personal assets, a foreclosure can trigger income tax consequences.
Hall notes that lenders usually want to get rid of foreclosed properties as quickly as possible and often will sell them at auction prices much lower than the true market value. If the house is listed or sold for less than the loan value, the homeowner will not only lose his house but also may have to pay income taxes on the difference because it is considered debt relief income.
For instance, if the foreclosed homeowner has a $500,000 loan and the lender sells the house for $450,000, the homeowner will have to pay taxes on the $50,000 difference. The $250,000 tax exemption for singles and $500,000 for joint filers does not apply to debt relief income, in this case the $50,000.
The tax owed on the debt relief is based on the homeowner's ordinary income tax rate, not the lower capital gain rates. The exclusion, however, may still be available to reduce any capital gains in the difference between the sales price and the homeowner's basis.
"Some would say that's a disaster, but it's better than having the lender take you to court, obtain a judgment and then go after (your other assets)," Hall says.
Hall recommends homeowners who are getting behind to talk to their lender to see if they can restructure the loan and/or payment terms. At the same time, they should seek financial counseling and tax advice.
If they have a recourse loan, they should consider selling before allowing a lender to foreclose to obtain the maximum sales proceeds and reduce their financial or tax exposure, Hall says.
Norm Bour, owner of Priority Plus Lending in Laguna Niguel, thinks there are some homeowners who should just cut their losses now.
"There are a lot of people who are homeowners who shouldn't be, living day to day just to support the house," he says.
"My advice to them: Sell."
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