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25 June 2013

Can A Bank Sue You After Foreclosure?

There have been recent articles addressing the possibility of lenders in recourse states coming back to collect the deficiency created by long-forgotten foreclosures. While it sounds scary, and can be a possibility, this is very unlikely based on our experience (and after working with 8,000+ homeowners over the course of 5+ years we think we’ve […]

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There have been recent articles addressing the possibility of lenders in recourse states coming back to collect the deficiency created by long-forgotten foreclosures. While it sounds scary, and can be a possibility, this is very unlikely based on our experience (and after working with 8,000+ homeowners over the course of 5+ years we think we’ve got a pretty good handle on the situation).

Not only do many states have fairly short statutes of limitations, but in many cases lenders have already given up the right to pursue any remaining debt by cancelling the debt and issuing the necessary tax documents.

After foreclosure, all borrowers will receive some version of a 1099. A 1099 is a tax form known as an information return. There are a number of different 1099 forms issued for various types of income that a taxpayer receives other than employment income. After foreclosure, the most common types of 1099s received are the 1099-A and 1099-C.

Do not confuse the two.

According to the Internal Revenue Service, “if you borrow money from a lender to purchase property, the lender may require the loan to be secured by the purchased property. If you transfer an interest in the secured property to the lender (such as in a foreclosure) or abandon the property, you may be required to treat the transfer or the abandonment as a sale of the property. If the lender acquires an interest in the secured property or has reason to know that you abandoned, or permanently discarded from use, the secured property, the lender should send you a 1099-A.” This is typically received by the borrower in the January following every foreclosure. On the Form 1099-A, the lender reports the principal amount of the debt owed and the fair market value of the secured property. The debtor will use these values to determine a gain or loss on the disposition of the property.

Some states have anti-deficiency laws. These states include Alaska, Arizona, California, Minnesota, Montana, North Carolina, Oregon, and Washington. The laws are not the same in every state, but each of these states has some form of protection for borrowers in certain situations that make them free of liability for any remaining debt following foreclosure. Other states do not have these laws, leaving them potentially liable for any deficiency. Lenders of recourse loans (loans for which there are no state laws to deem any remainder uncollectable) have three choices: write off any remaining debt as a loss, sell it to a third party debt collector or pursue a deficiency judgment. In other words… Sue you after foreclosure for the amount they lost in the deal.

If the lender chooses to write the debt off (and this has happened in a significant percentage of cases based on our experience), the borrower will receive a 1099-C. According to the Internal Revenue Service, “when you borrow money, you are not required to include the loan proceeds in gross income because you have an obligation to repay the lender later. If that obligation is subsequently canceled, you may be required to include the amount of the canceled debt in gross income.” The issuing of a 1099-C is the lender’s report of cancelling the debt.

A 1099-C normally creates liability in the amount of the canceled debt. However, the Mortgage Forgiveness Debt Relief Act of 2007 protects some taxpayers who have experienced a foreclosure from being liable for taxes on that amount. The Act, recently extended through 2013 as part of ‘fiscal cliff’ negotiations, excludes from taxation discharges of up to $2 million of indebtedness that is secured by a principal residence and was incurred as a result of the acquisition, construction or substantial improvement of the property. This means that homeowners who receive a 1099-C as a result of foreclosure on their primary residence, and who never pulled money out for anything other than the acquisition, construction or substantial improvement of the property, are not required to include the amount forgiven as taxable income. Debt used to refinance a property qualifies for the exclusion, but only to the extent that the principal balance of the old mortgage, immediately before the refinancing, would have qualified.

So, just because you didn’t get stuck with a huge tax bill does not mean that you’re in deficiency limbo. By issuing a 1099-C, the lender has acknowledged giving up their legal right to pursue any remaining debt. Congratulations, you’re free!

With that understanding, now you know if your bank can sue you after foreclosure or not.

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