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California Code of Civil Procedure and Foreclosures

In our July 2009, October 2009, and November 2009 issues of Tax News we addressed some of the questions related to foreclosures.

Another question we receive regularly asks:

Will you clarify how California civil procedures interact with the Internal Revenue Code (IRC)? Specifically how does California Civil Procedure Code (CCP) Sections interact with IRC Section 108, Income from Discharge Indebtedness?

These clarifications are critical in view of the large number of foreclosures.

Property law is governed by state law. As such, federal law looks to California property law to determine the answers on recourse or nonrecourse financing.

California has a complicated set of rules concerning foreclosures and alternate rules for foreclosures.

Judicial or Nonjudicial Proceeding

The primary method of foreclosure in California involves what is known as a nonjudicial foreclosure sale. This type of foreclosure does not involve any court action. Instead a foreclosure sale proceeds pursuant to a "power-of-sale" contained in a deed of trust. (A deed of trust grants a security interest in real property to a creditor.) Nonjudicial foreclosure sales in California have stringent notice requirements and the deed of trust must contain power-of-sale language in order to use this type of foreclosure.

If a creditor completes a foreclosure through nonjudicial means, it is barred from recovering a deficiency judgment against the debtor, regardless of whether the loan was recourse (meaning the creditor potentially has recourse to all the property owned by the debtor) or nonrecourse (meaning the creditor's remedy is limited to the sale of collateral securing, and application of the proceeds towards payment of, its debt).1

In the case of recourse loans, lenders can forego their rights under the power-of-sale in a deed of trust and file a lawsuit in a "judicial foreclosure proceeding." If they prevail, the court will grant a judgment of foreclosure. CCP Section 725(a) provides a beneficiary or trustee named in a deed of trust or mortgagee named in a mortgage with power-of-sale upon real property has the right to file a lawsuit to foreclose.

CCP Section 726, commonly known as the "one-action rule," restricts the remedies available to lenders. CCP Section 726(a) provides that, "There can be but one form of action for the recovery of any debt or the enforcement of any right secured by a mortgage upon real property…" Moreover, CCP Section 726 requires the lender to first look to the sale of the collateral security for satisfaction of its debt and prevents the lender from bringing more than one action against the debtor. Therefore, if the creditor prevails on its lawsuit for foreclosure, the court will direct the sale of the encumbered property and the application of the proceeds to payment of the creditor's costs and indebtedness. If the proceeds from the sale fail to satisfy the costs of the foreclosure and indebtedness, the creditor can apply within three months following the sale for a deficiency judgment. Upon such application, and establishment of a deficiency, the court will render a money judgment against the debtor for the amount of the deficiency.2

California law bars deficiency judgments for loans incurred to pay all or part of the purchase price of buildings consisting of one to four residential units, providing the borrower is an occupant. In other words, debt incurred to purchase owner-occupied residential property in California having no more than four residential units is nonrecourse, even if the building contains up to three rental units besides the borrower's personal residence. Moreover, California law bars deficiency judgments for loans where the seller of the property financed the sale.3

A debtor is treated as having sold or exchanged foreclosed on property when he transfers it to his creditor in discharge of his debt.4 In a foreclosure sale of property subject to a mortgage or deed of trust, the amount realized includes the amount of the indebtedness securing the property.5 But the amount realized on a foreclosure sale involving a recourse liability does not include any portion of the indebtedness forgiven by the creditor. However, if the fair market value (FMV) of the property is less than the cancelled debt, the amount realized by the debtor includes the cancelled debt up to the FMV of the property.6

If the loan is recourse indebtedness and the debtor incurs cancellation of indebtedness income (CODI), IRC Section 108 provides certain exceptions in recognition of that income. One of the exceptions applies where the taxpayer was insolvent (total liabilities exceed total assets) when the CODI was realized. The exclusion only applies up to the amount of insolvency, i.e., to the extent the liabilities exceed the FMV of the assets. Others exceptions are available for the cancellation of Qualified Real Property Business Indebtedness, the cancellation of Qualified Farm Indebtedness, or court approved debt cancellation while the debtor is in a Chapter 11 bankruptcy.7 However, California law does not conform to all of the provisions currently available in IRC Section 108.

Where a nonrecourse debt is cancelled in exchange for a transfer of the property securing the debt, the transfer is treated as a sale or exchange of the property and the amount realized is the amount of the debt, even if the amount of the debt is more than the FMV of the property. Gain is recognized to the extent the debt securing the property exceeds the adjusted basis of the property.8

In instances where the FMV of a property falls significantly below the balance owing on a loan secured by that property, a lender may consent to the borrower's sale of the property to a buyer for less than the full amount of the loan and forgive part of the loan (commonly referred to as a "short sale"). The forgiven part of the indebtedness would be subject to the rules mentioned above and the exceptions described below. A modified version of IRC Section 108(h) excluded CODI resulting from foreclosures or short sales of qualified principal residences for California tax purposes in 2007 and 2008, but does not apply to any foreclosure or short sale that occurred on or after January 1, 2009.

Under federal law, there is an exclusion of $2 million for foreclosure gain on a principal residence incurred before 2013. The exclusion is reported on IRS Form 982.9 California has not conformed to this exclusion.

In addition, pursuant to IRC Section 121, individuals may exclude up to $250,000 ($500,000 for married persons filing jointly) of capital gain realized from the sale or exchange of a principal residence. California conforms to IRC Section 121, although the excluded amounts are less for sales occurring on or before October 22, 2004.10

In instances where the lender forgives part of its indebtedness (regardless of whether the loan is recourse or nonrecourse), but does not require a surrender or sale of the property, the forgiven portion of the indebtedness is taxable pursuant to IRC Section 61(a)(12). However, that income may be subject to exclusion by one of the exceptions provided in IRC Section 108. The primary method of foreclosure in California involves what is known as nonjudicial foreclosure. This type of foreclosure does not involve court action.

Additionally, the IRS has issued several informative articles and publications on foreclosures/short sales available at

1See CCP Section 580d.
2See CCP Section 580a.
3See CCP Section 580b.
4See Rev. Rul. 90-16, 1990-1 CB 12.
5See Treas. Reg. § 1.1001-2(a)(1).
6See Treas. Reg. § 1.1001-2(a)(2) and IRS Pub No. 544, (2008), p. 5.
7See IRC Section 108(a)(1).
8See Gershkowitz, Herbert, (1987) 88 TC 984.
9See IRC Section 108(a)(1)(E).
10See CA R&TC Section 17152.

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