Information Letter Notice 2013-0036 and Why California's Anti-deficiency Statues Convert Recourse Debt to Nonrecourse Debt

• Jurisdiction: California,United States,Federal
• Author: By Douglas L. Youmans and N. Aaron Johnson
• Citation: Vol. 23 No. 4
• Publication year: 2015

Information Letter Notice 2013-0036 and Why California's Anti-Deficiency Statues Convert Recourse Debt to Nonrecourse Debt1

By Douglas L. Youmans and N. Aaron Johnson²

EXECUTIVE SUMMARY

In response to a letter Senator Barbara Boxer sent to the Internal Revenue Service (the "Service") in 2013, requesting clarification as to whether a short sale conducted pursuant to section 580e of the California Code of Civil Procedure ("CCP") resulted in cancellation of indebtedness ("COI") income, the Service issued Information Letter Number 2013-0036 ("ILN 2013-0036"). ILN 2013-0036 states, "We believe that a homeowner's obligation under the anti-deficiency provision of CCP section 580e would be a nonrecourse obligation to the extent that, for federal income tax purposes, the homeowner will not have cancellation of indebtedness income. Instead, the homeowner must include the full amount of the nonrecourse indebtedness in amount realized."³

On April 29, 2014, the Service issued a clarification of ILN 2013-0036 ("4/29 Clarification") which stated that they had been overly broad in, "... extending our analysis of the federal tax treatment of obligations beyond those [purchase money obligations] described in section 580b(a)(3)."

The authors believe that the position the Service took in ILN 2013-0036 is supported by a plethora of cases following Crane⁴ and Tufts⁵ which distinguish recourse from nonrecourse debt based on whether the debtor is subject to a deficiency judgment at the time the debt is discharged.

The authors further believe that the position adopted in ILN 2013-0036 should not be limited to short sales conducted pursuant to CCP section 580e. Rather, ILN 2013-0036's analysis should be extended to other anti-deficiency statutes and "reinforced" by issuance of some sort of "substantial authority" concluding that, to the extent an anti-deficiency statute eliminates a debtor's personal liability with respect to a debt following the disposition of any collateral securing that debt, the debt should be treated as nonrecourse at the time of the disposition which triggers application of the anti-deficiency statute.

I. DISCUSSION A. Background

As evidenced by Senator Boxer's August 28, 2013, letter to Daniel Werfel, acting Commissioner of the Internal Revenue Service, taxpayers, their tax return preparers and counsel (collectively, the "Tax Practitioner Community") and others have long struggled with the tax consequences flowing from the discharge of debt secured by real property, particularly if there is a disposition of any real property security in conjunction with and as consideration for all or any portion of that discharge of debt (hereinafter, property held as security for a debt may be referred to as "Collateral"). Part of the confusion could be attributable to the fact that, for purposes of ascertaining the tax consequences of such a discharge, different rules apply depending on, among other things, whether the debtor is personally liable for the debt, whether the debtor disposes of all or any portion of the Collateral in conjunction with and as consideration for all or any portion of that discharge and whether the outstanding loan balance immediately preceding the discharge exceeds the value of the Collateral at the time of its disposition.⁶

Adding to the confusion created by the alternative outcomes which could flow from any particular "mix" of the aforementioned variables is the fact that a number of states, California being one of them, have adopted what are often referred to as "anti-deficiency" statutes. Those statutes effectively preclude a creditor from pursuing a debtor for collection of any "deficiency judgment" if the value of any Collateral ends up being less than the outstanding loan balance at the time the debt is discharged.⁷ Moreover, the mortgage crisis and dramatically declining home prices prompted Congress to enact the Mortgage Forgiveness Debt Relief Act of 2007,⁸ which added section 108(a)(1)(E) to the Internal Revenue Code of 1986, amended (the "Code"). Section 108(a)(1)(E) of the Code excluded from gross income, income realized prior to January 1, 2010, as a result of the discharge of "qualified principal residence indebtedness ("QPRI"),"⁹ regardless of whether any such discharge occurred as a result of a short sale, deed in lieu, foreclosure, or simply a refinance. Because the housing market took longer than expected to "recover," the Emergency Economic Stabilization Act of 2008,¹⁰ extended the original January 1, 2010 sunset date to January 1, 2013, and the American Taxpayer Relief Act of 2012,¹¹ further extended it to January 1, 2014.¹²

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Questions with respect to how Code section 108(a)(1) (E) interacts with one of California's anti-deficiency statutes (CCP section 580e) appear to have prompted Senator Boxer to send the aforementioned August 28, 2013, letter (the "Boxer Letter"), requesting an answer to the following question: "Would a household realize a cancellation of debt if a lender elected to approve a short sale, which by operation of the state's law would mandate a discharge of recourse debt (as California's Civil Code Section 580e does), and at which time the borrower is released from personal liability on the indebtedness secured by the mortgage?"

On September 19, 2013, Michael J. Montemurro, Associate Chief Counsel of the Service, responded to the Boxer Letter (the "9/19 Response"), stating that, "We believe that a homeowner's obligation under the anti-deficiency provision of section 580e of the CCP would be a nonrecourse obligation to the extent that, for federal income tax purposes, the homeowner will not have cancellation of indebtedness income. Instead, the homeowner must include the full amount of the nonrecourse indebtedness in amount realized."

The Service released the 9/19 Response to the public in November 2013, and adopted it as Information Letter Number 2013-0036 on December 27, 2013 ("ILN 2013-0036").

While the California Tax Practitioner Community has debated the impact of ILN 2013-0036, and the soundness of the logic on which it is premised, groups such as the California Association of Realtors have circulated it among their members and questioned whether the statement contained therein that CCP section 580e has effectively "converted" what might have appeared to be recourse debt to nonrecourse debt can and should be "extended" to all anti-deficiency legislation.¹³

On April 29, 2014, Mr. Montemurro, on behalf of the Service, issued a clarification of ILN 2013-0036 ("4/29 Clarification") which stated that the analysis in ILN 2013-0036 was "overly broad." Correctly reading CCP section 580b(a)(3) to mean that, ". . . a lender has no recourse against a homeowner for a deficiency following either a foreclosure or a lender-approved short sale when the mortgage secures a purchase money loan described in section 580(b) (3)" (emphasis added), the 4/29 Clarification goes on to say,

Consequently, for federal income tax purposes, a purchase money loan between a lender and mortgagor that is described in section 580b(a) (3) is, from its inception, a nonrecourse loan. Therefore, upon the foreclosure or short sale of a principal residence when a mortgage secures such a purchase-money loan, the amount realized on the sale is determined under Commissioner v. Tufts, 461 U.S. 300 (1983).... Section 580b(a)(3) of the CCP applies only to purchase-money loans to acquire a principal residence. Section 580e, however, applies to both purchase-money loans and non-purchase-money loans, and applies to property that may or may not be the taxpayer's principal residence. Non-purchase-money loans subject to California's anti-deficiency statutes generally appear to be recourse loans from their inception. We were overly broad in our prior response in extending our analysis of the federal tax treatment of obligations beyond those described in section 580b(a)(3). (Emphasis added.)

Senator Boxer responded to the 4/29 Clarification on May 21, 2014 ("Boxer Letter #2"), seeking further clarification, particularly with respect to the Service's change of position.¹⁴ As of the date of this paper's submission, the Service has not responded to Boxer Letter #2.

Since the authors believe ILN 2013-0036 clearly follows Crane,¹⁵ Tufts¹⁶ and their progeny,¹⁷ and the 4/29 Clarification inappropriately and unreasonably narrows ILN 2013-0036's scope (purportedly by distinguishing among anti-deficiency statutes that are not really different), this paper is intended to explain not only how ILN 2013-0036 is supported by both California's anti-deficiency legislation and federal tax law, but why the position the Service took in ILN 2013-0036 should be expanded and expressed in some format which is considered "Substantial Authority" (such as a Revenue Ruling).¹⁸

B. Treatment of Recourse and Nonrecourse Debts

To understand why the authors believe ILN 2013-0036 clearly follows Crane,¹⁹ Tufts²⁰ and their progeny,²¹ one must understand the various factors impacting the determination of the amount and character of any income realized as a result of a discharge of debt. Accordingly, this paper shall analyze the rules which apply: (i) when a debtor is nongratuitously discharged from all or a portion of a debt and retains the Collateral; (ii) when a debtor sells or disposes of Collateral in conjunction with the discharge of a debt; (iii) when the fair market value ("FMV") of any Collateral transferred in connection with a discharge of debt becomes relevant; (iv) when the character of the debt discharged in conjunction with a disposition of Collateral becomes relevant; and (v) when some of California's anti-deficiency statutes (like CCP section 580e) become relevant.²² That analysis shall begin with a review of the definitions of the terms "recourse" and "nonrecourse."

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Historically, the Service and the Tax Practitioner Community have distinguished "recourse" debt from "nonrecourse" debt based on whether the debtor is personally...