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California is doomed for two simple but profound reasons: the cost structure is too high for most businesses to survive, and a boom-dependent economy.

The dysfunctions crippling California would easily fill a volume: a dysfunctional Legislature that has been gerrymandered to protect virtually every seat; a dysfunctional proposition system which enables special interests to craft Protected Fiefdoms via the ballot box; recalcitrant public unions who don’t see anything wrong with public servants getting 90% of top-pay in pensions while still earning big bucks as “contract employees,” an enormous population of undocumented workers who pay only sales taxes, and whose employers pay no payroll taxes, either– and that just scratches the surface. I want to highlight two systemic, structural causes for California’s impending bankruptcy as a state and as an “economy”: a crushingly high costs structure and an economy entirely dependent on the next boom.

I know this sounds too simplistic to be meaningful, but I think there is much truth in this statement: Costs are too high because the guy before you paid too much.

In other words, you can’t afford the $500,000 mortgage on the $625,000 house you bought in 2008 because the guy before you paid $550,000 for a house which sold for $140,000 in 1997.

These numbers are drawn from reality: our friends bought a small home in a desirable suburb in the San Francisco Bay Area for $140,000 in 1997. Yes, it was a fixer-upper and yes, our friends completely remodeled it. The fair value of the house after renovation was probably in the $175,000 to $190,000 range, tops.

They sold the house in 2005 for $550,000, and that buyer unloaded the house in 2008 for $625,000.

This represents approximately $235,000 of actual value (the $175,000 adjusted for inflation from 1997 to 2010 as per the BLS inflation calculator) and $390,000 of “credit-bubble” excess.

Yet that “bubble valuation” is an actual cost now that somebody borrowed money to pay that grossly inflated price. This mechanism is absolutely key to understanding the California economy’s fundamental insolvency: the apartment rent is high because the landlord overpaid, the office rent is high because the landlord overpaid, the house is too high because the previous owner overpaid and his/her lender ponied up the mortgage based on bubble valuations.

You can see the bubble in this chart of median home prices in Califonia:

It even explains why Napa Valley is going bust, as this story submitted by frequent contributor U. Doran reveals: Vineyard Defaults Surge as Bargain Wines Hurt Napa Valley.

Wine costs are partly driven by the fact that the last guy grossly overpaid for vineyard land. Now the lenders are scrambling, but it’s all too late; bubbles burst, and sadly for the lenders and those who bought at the top of the bubble, there will be no boom to save them.

Hunkering down and awaiting the next boom is a strategy as old as the state itself. When the easily plucked gold in the Sierra Nevada ran out, the economy based on supplying distant mining camps died right along with hundreds of those camps.

But then the Comstock Lode of silver was discovered in Nevada, and California–especially San Francisco–was bailed out by a veritable flood of fresh wealth pouring out of the mines.

More recently, the fall of the Soviet Union in the early 90s gutted the defense industry which had been a mainstay of the California economy since World War II. That “depression” lowered real estate values and caused many bankrupcties, personal and business alike.

But then the biotech and personal computer/software revolution took hold (the Macintosh took off as the laserprinter revolutionized desktop publishing, etc.) and the next boom was under way. Tax revenues skyrocketed and Silicon Valley was the envy of the world, sparking wannabe “incubators of wealth” from New York (Silicon Alley) to Malaysia and beyond.

While no boom runs white-hot forever, the residents of California have come to expect a new bubble/boom to arise to fuel rising tax revenues and real estate valuations. Just as the PC revolution peaked (1995’s “Start Me Up” Windows launch (as the bumper sticker had it, “Mac 1985, Windows 1995″), then the Internet boom started, triggering a frenzy of overinvestment and bubblicious valuations.

After that bubble burst in 2001, hot-spots in San Francisco and the valley lost some luster, and about 120,000 workers lost their jobs and left Northern California. But once again, a new wave of web-enabled businesses arose: Netflix, the Google juggernaut, Apple reclaimed the crown of global device/software integration innovation, Twitter, etc. etc.

But the current Web 2.0 boom is not generating a flood of new wealth which spreads over the landscape. Twitter has about 100 employees and might double to 200. Apple employs a few thousand people in Cupertino but all its manufacturing is done elsewhere.

What nobody seems to notice is that Web 2.0 is all about leveraging automated software. You don’t need 10,000 people to run Twitter or Facebook.

And as I noted yesterday, these Web 2.0 businesses based on advertising revenues are inherently limited to the pool of available advertisers whose adverts are actually generating revenues. You can’t reinflate a trillion dollars of real estate with 200 employees.

California is now the world capital of Denial. Everyone from the State legislature to union officials to realtors to small business owners are hanging on, refusing to face the fact that there will be no boom to save them and the state, To survive one more year, they’re borrowing money, hiding debts and real valuations, monkeying with the books and playing accounting tricks, borrowing from next year’s revenues, selling bonds–anything to maintain the artifice of solvency for 2010 so the next boom (conveniently scheduled for 2011) will lift real estate values, create hundreds of thousands of high-paying jobs and launch entire new industries.

Welcome to the Golden State of Denial. Without another global bubble–for California is a global economy–then California is doomed to insolvency at every level, public and private.

A return to historical levels of real estate valuations will bankrupt every lender and every owner with debts based on bubble valuations. State and local governments are thus doubly doomed, as their property tax revenues dry up and payroll taxes dwindle along with the job count.

I have covered the pernicious effects of a high cost structure before: Lowering the Cost Structure of the U.S. Economy (August 29, 2008)

California’s entire cost structure is based on bubble/boom valuations and the vast tax revenues generated by those bubbles/booms.

The problem in California is everything costs too much: auto insurance costs more, gasoline costs more, taxes are near the top, especially on those households who make more than $100,000 a year, sales taxes are basically 10%, workers compensation insurance, business licenses, vehicle taxes, State Park admission/parking fees, rent, housing, and on and on.

The state and all its local governments have grown fat on endless bubbles and booms, and are now refusing to face the long lean years ahead. California is like the pilgrim who gets saved by a miracle at every turn. The economic miracles can’t run out, because we’ve always been saved before.

As the disclaimer puts it: past performance is not a guide to future performance.

In some ways, California’s dependence on bubbles and booms mirrors the nation as a whole; as with so many things, California has just extended the fantasy further.

This article originally appear on the Irvine Housing Blog

The ARM Problem has not gone away. Today we examine an updated ARM reset schedule and consider its impact on our local housing market.

it’s time for me to get away from here
just thought you oughta know the end is near
did you honestly think it would’ve worked at all
cuz evrything i’ve seen has only made me fall
there ain’t much i can do now that i’ve seen the truth
there ain’t much i can do now they’ve made me into
one of you

REPENT
for the kingdom of oblivion is at hand
REGRET
not a thing for all’s as it was planned
REJECT
false gods false hopes and false ideals
RESET
push the button game over no more time to steal

Left Spine Down — Reset

Wouldn’t life be much easier if we could hit a reset button and wipe away the excesses of the housing bubble? In the housing bubble era, reset is associated with a bad thing that happens to adjustable rate mortgages. I remember last year a few astute observers much wiser than me chastised me for worrying about adjustable rate mortgages because they were all resetting to lower rates — problem solved. Foolish me. I must be a Chicken Little sounding a false alarm, right?

I wrote most recently about The ARM Problem in the summary post Option ARM story. The problem with adjustable rate mortgages resetting and recasting to higher payments has diminished in importance because many of the loans have defaulted early, so now the major problem is shadow inventory. The ARM problem is still with us, and much of our shadow inventory — and ultimately foreclosure and resale inventory — is spawned from this lending monster.

$1 trillion worth of ARMs still face resets

By Zach Fox

While several industry observers worry about negative equity and unemployment driving foreclosures, a couple of experts point out that interest rates on mortgages remain a cause for concern.

Credit Suisse made waves in 2007 among housing bears with a chart that estimates the volume of adjustable-rate mortgages to face a reset each month. An updated version of the chart, which was provided to SNL, shows resets remain a worrying force over the next few years.

Most of the resets are expected to occur through 2012. Between 2010 and 2012, the chart indicates that $253.25 billion of option ARMs will adjust, while Alt-A loans totaling $163.71 billion will reset over that time. Altogether, $1.010 trillion worth of ARMs will reset or recast during the three-year period.

“Option ARM resets are still pending. … Nothing much has happened yet because rates were so low that resets were pushed back,” Chandrajit Bhattacharya, head of non-agency RMBS and ABS strategy at Credit Suisse, told SNL.

That is not entirely true. Many of these loans are still pending, but the borrowers are not paying. The reset chart is not adjusted for shadow inventory. Many of the loans facing reset are already in default. Numerous of the light blue (Option ARMs) have already defaulted as have many of the light green (Alt-A loans).

Borrowers who already have seen their ARMs reset might be sitting on their hands and not refinancing into fixed-rate products, McBride said. Because mortgage rates have been so low recently, resets can actually lower, not raise, monthly payments. When that happens, borrowers might feel little urge to refinance into a fixed-rate product that would cost more per month.

This is the real problem; people will do anything, no matter how foolish, to lower their monthly payment because they believe the government will bail them out if interest rates move against them. Why wouldn’t they? Moral hazard caused by lending bailouts emboldens both lenders and borrowers and ultimately increases the cost of the bailouts demanded.

“The avoidable scenario is interest rates start to go up over the next couple of years, and all of a sudden, millions of homeowners who are stuck in adjustable rate mortgages and haven’t been able to refinance out of them become sitting ducks for big payment increases,” McBride said. “And then here we go again. It’s like 2007 all over again. And again, the HARP program is key to avoiding that iceberg, and we’re headed right for that iceberg, and no one’s turning the wheel because everyone’s focused on mortgage modifications.”

“If you look at it, there’s almost probably 5 million borrowers sitting there in some sort of delinquency right now who have yet to be foreclosed upon. So if you say [the Home Affordable Modification Program] is going to save only a small fraction of that, the rest of them have to go through in some form of foreclosure or distressed sale,” Bhattacharya said. “So it’s definitely not over by any means.”

Credit Suisse projects 10 million foreclosures over a five-year period starting in 2008.

To put the ARM resets schedule in context, these timelines represent the totality of the carnage the markets face from ARMs, but the actual foreclosures related to these loans may occur early due to unemployment, negative equity or a number of other reasons. Shadow inventory emerges from this schedule and pulls destruction forward. Loan modifications, which are supposed to be the market savior, increase the problem with terms that have escalating interest rates and increasing payments. So why is this a big deal here in California?

… option ARMs are concentrated in just a few states. A Fitch Ratings study from Sept. 8, 2009, The Building Block: Bringing \’cram-down\’ back’,PU_STATUS,’9/14/2009 The Building Block: Bringing \’cram-down\’ back’,PU_CAPTION,’Article’,PU_POPOFF,0));”>reported that three-quarters of all option ARMs were in California, Florida, Nevada and Arizona.

Don’t worry; Irvine has none of those problems, right?

More Foreclosures are Coming

From the OC Register: Foreclosures now are just ‘tip of the iceberg’:

[Bruce] Norris told hundreds of investors attending a seminar he held in Costa Mesa this past weekend that numbers indicating the appearance of  firming home prices and fewer foreclosure auctions are “illusions.”

Government repayment and loan modification programs make foreclosure numbers appear lower for now, but are delaying the inevitable inability or disinclination of homeowners in trouble to hang on to property that has dropped in value by hundreds of thousands of dollars, he says.

Meanwhile, he says,  redefaults on loan modifications are “sabotaging” government efforts.

Mortgage delinquencies will continue “skyrocketing,” he says, because:

• “The resets of the Option-Arm loans will cause a larger number of foreclosures than the subprime loans.
• “Resets are part of the problem, but a bigger concern is the owners who owe more on their home than it’s worth.
• “Commercial loans and credit card losses will soon add to the problem.”
• Unemployment is a signifcant factor. He says: “I think we will fall back into recession by the end of 2010, and the unemployment rate and underemployment rate will be about 20% in 2011.”
• Owners are finding it more and more acceptable not to make their house payments. The mindset, according to Norris: ” ‘I see my next door neighbor has stopped making his payment, and he just bought a camper.’ You can see that coming. We haven’t really been through the biggest part of the problem.”

Updated ARM Reset Schedules

For historical reference, I superimposed the new reset chart onto the old one to see how the original projections have changed.

In the cleaned up graphic below shows the next four years of adjustable rate mortgage resets.

More reason to believe the Bernanke Put, the implied protection of mortgage interest rates, is going to be kept in place.

The results of amend-pretend-extend are apparent, and in case the obvious is overlooked, restructured loans only postpone bank losses.

The amend-pretend-extend policy is like shovelling snow; the more you push the snow, the larger the build-up on the front of the shovel. Eventually, you will need to stop and remove the snow or you get stuck. Similarly, pushing ARMs out further simply adds to the problem and makes correcting the problem costier.

Lenders believe that a rolling loan gathers no loss, so they would push the problem back endlessly if they could. Eventually, appreciation may bail them out, but the existence of these loans and the inevitability of higher interest rates will weaken appreciation or kill it entirely. Also, despite the foolishness of it, many of these loans are being underwritten today as affordability products. Rather than eliminating ARMs at the bottom of the interest rate cycle, we are expanding their use.

If the ARM problem becomes large enough, politicians will deem it too-big-to-fail and engineer another bailout. At this point it is difficult to advise people to take on conservative financing and do the right thing. So much moral hazard exists that I can not persuasively argue with someone considering an ARM loan. The system is there to be gamed, and everyone seems OK with that. Personally, I find it appalling.

For thousands of Californians who did a short sale or had mortgage debt forgiven via a modification in 2009, Monday is a big day.

The Sacramento Bee reports California tax law unsettled on home sellers’ short sales

Monday, the Assembly is scheduled to vote on SB32 X8, a bill by Sen. Lois Wolk, D-Davis, that would ban the state from taxing mortgage debt forgiven in 2009.

But Schwarzenegger is threatening to veto the bill over an obscure clause opposed by business groups. That clause establishes new tax penalties on firms that file unfounded claims for refunds. Business associations believe it will unfairly punish them for tax withholding decisions they claim are difficult to calculate. The clause, along with forgiven mortgage debt, is among dozens in the bill to align California’s tax codes with federal codes.

The governor wants the business penalty provisions stripped from the bill, said his spokesman Mike Naple.

“The governor would prefer that the provision be taken out of the bill and addressed in separate legislation,” Naple said.

The state gave homeowners who occupied their homes a pass on forgiven mortgage debt in 2007 and 2008. The federal government, meanwhile, has backed off on taxing forgiven mortgage debt through the end of 2012. In the past, both branches of government treated forgiven debt as taxable income.

Forgiven similar legislation has passed before and this will almost certainly pass again, with or without this extra clause. Still, I’m sure many of us will sleep better after it’s signed.

Originally posted at the Irvine Housing Blog.

Today we look at one family in San Diego hoping for debt forgiveness that isn’t going to happen.

Love is like oxygen
You get too much you get too high
Not enough and you’re gonna die
Love gets you high

Time on my side
I got it all
I’ve heard that pride
Always comes before a fall

Sweet — Love Is Like Oxygen

Appreciation is like oxygen, you get too much prices get too high, not enough and your gonna die — or at least be forced to pay down debts – a fate antithetical to a borrowing dependant lifestyle.

Recently, I wrote about The Coming Tax Nightmare Over Forgiven Mortgage Debt in California, and recently another story was written about the Hefty tax bill may hit those who lost home.

San Diegans who have lost their homes through foreclosure or short-sales thought they had emerged from the dark times and could start rebuilding their lives.

Then the state tax man came calling.

With less than six weeks before taxes are due, an estimated 16,000 former homeowners statewide will owe $15 million in extra income taxes this year and $29 million through 2012.

Today we look at one family lamenting the $20,000 tax bill they must pay for their failed speculation.

[March 2, 2010 | Photo by Charlie Neuman. Bonnie and Clyde are facing a California tax bill of up to $20,000 because, they have found, the state treats short-sales differently than the IRS.]

Phyllis Roth, 63, a tax preparer, said she did not realize until recently that the state would treat the short-sale differently than the Internal Revenue Service would. She estimates her state taxes at $15,000 to $20,000.

“I didn’t call anybody,” she said. “I was looking online and didn’t see anything. That’s what happens when you rely on yourself.”

Brilliant marketing for her tax preparation business, “Let me help you miss a $20,000 tax obligation. I did.”

For the Roths, who continue to own a previous home and have other assets, their nearly $200,000 in losses does not cancel out their other holdings. The couple said they normally operate conservatively and only bought the home, which they lived in while their son continued to live in their first house, so they could sell it at a profit and pad their retirement accounts.

“If we have to pay it, we’ll pay it,” Phyllis Roth said of the taxes. “It’s less money to retire on, but it’s not the end of the world.”

If we have to pay it? Sure, let’s take our broken State budget and carve out a tax break for HELOC abusers and everyone else who lost money speculating in the housing market. That should provide a great incentive for frugality and curb speculation. Not.

Congress exempted most homeowners from the extra federal tax through 2012, and the state followed suit for 2007 and 2008 but did not extend the provision last year. The state Assembly may vote tomorrow on a bill to repeal the tax, but Gov. Arnold Schwarzenegger vetoed such a bill last year over unrelated provisions.

“The state of California is seriously upside down financially, and I think the governor will probably veto it again,” Nemeth said.

H.D. Palmer, a spokesman for the Department of Finance, said Schwarzenegger remains opposed to the bill in its present form but has not announced whether he will veto it again. Other versions of the tax repeal are in the hopper and could be passed next month, legislators’ analysts said.

Failure to halt the tax could cost Jack and Phyllis Roth of Fletcher Hills as much as $20,000 in state income taxes this year — they paid $781 last year — because of the home they sold short in Flinn Springs in November. They bought it in 2004 for $545,000, invested $50,000 in improvements, and then saw its value fall by one-third before they sold it for $410,000. The result was about $190,000 in net loss that was forgiven by the Roths’ lender.

Notice the words the reporter selected, “They bought … invested.” They did neither of those things; they borrowed. These people put no money down, borrowed another $50,000, sold for a $190,000 loss, and they are complaining because they might lose $20,000 of their money in taxes. We are not saving an already injured party from further pain, we are removing the only real pain these people will feel.

[schadenfreude alert] The state Franchise Tax Board has received an increasing number of calls from former homeowners who are discovering the giant tax bills they face, said spokeswoman Denise Azimi. Azimi said the former homeowners can work out a payment schedule, though the state charges 4 percent interest on such stretched-out payments.

If the tax is repealed eventually, the taxpayers could seek a refund, but for now, they have to pay what is due by April 15 or face a penalty.

Sen. Lois Wolk, D-Davis … who chairs the Senate Revenue and Taxation Committee, said it was appropriate to group all tax conformance measures into one bill. But if her bill is vetoed again, she indicated she would act to get the cancellation of debt tax repealed.

“We’re certainly not going to allow homeowners to have to pay significantly more tax when they’ve had to relinquish their homes through short-sales (and foreclosures),” Wolk said.

Why not? People who have non-recourse purchase money mortgages are not getting a tax bill. It is only investors, speculators, multiple-property owners, HELOC abusers and others with recourse loans who are getting a break. They are not a group who needs subsidies.

Insolvency

Every borrower will try to establish insolvency as defined by the Internal Revenue Service:

Do not include a canceled debt in income to the extent that you were insolvent immediately before the cancellation. You were insolvent immediately before the cancellation to the extent that the total of all of your liabilities exceeded the FMV of all of your assets immediately before the cancellation. For purposes of determining insolvency, assets include the value of everything you own (including assets that serve as collateral for debt and exempt assets which are beyond the reach of your creditors under the law, such as your interest in a pension plan and the value of your retirement account). Liabilities include:

• The entire amount of recourse debts, and
• The amount of nonrecourse debt that is not in excess of the FMV of the property that is security for the debt.

As defined by the IRS, insolvency is a condition of negative net worth; in other words, if you have no assets for the IRS to take, they will leave you alone. True or not, the incentive to feign and declare insolvency is huge.

How many people are filling false tax returns claiming insolvency when in reality, they just don’t want to pay, and they hope they can cheat and get away with it?

Inquiring minds might be wondering what they should do if they are struggling in a commercial real estate deal. Here’s a question along with an answer from my “California Business Banker” friend.

“Struggling In Atlanta” writes:

Hello Mish,

We purchased a small commercial building in Atlanta in late 2007 for $1.3 million. In an attempt to be prudent, we put 30% down and opted for a fixed rate mortgage. We got a 7.25% rate by entering into a separate interest rate swap with the bank tied to Libor.

In 2008, our major tenant went bankrupt but we were able to replace them 3 months later with a new tenant. However, the new lease rate was about 30% below what we had from the previous tenant. Since then, we have added new tenants and are almost at the prior income level, but we still are not making a profit.

Here’s my question: Do banks have any incentive to come back to the table with us and renegotiate our loan before we start making late payments?

We can keep up, but only by contributing some savings. I know the banks don’t want to be landlords but what is the best way to approach this with our bank?

Thanks for any assistance.
Struggling In Atlanta

Hello SIA, I have no practical experience in these situation but my commercial banker friend does. I bounced your email off “California Banker” who replied …

Hi Mish

In regards to your friend in Atlanta with the commercial real estate investment that has turned over. The first thing they should understand is they are not alone. Finally, commercial real estate has caught up with the residential market, and I see a lot of people who have the very same issues. I actually have a client going through this issue with another bank.

There are three things I would encourage them to understand or research:

1) Virtually all commercial real estate loans are not reported to personal credit agencies, so it’s highly likely a delinquent commercial real estate won’t impact their personal credit.

2) They should review their loan documents to see if they signed as guarantors, which essentially puts their personal net worth on the hook. Given the interest rate swap loan, they might not have, which would be good, but the answer impacts their strategy.

3) Lastly, they should check their documents for a prepayment penalty which is very standard on fixed rate loan. And given the swap type loan I would guess they have the Yield Maintenance type which is typically an eye popping penalty.

Step one in their plan: Take their loan docs, their tax returns, and personal financial statement, and see an attorney that specializes in real estate, “NOW”. Far too many people wait until the end of the process, when it’s to late.

Step two, “The Bank”: I haven’t heard of too many banks looking to help someone while they are current on loan payments. It’s the community banks that seemed to be more proactive when a problem arises. So, after a visit with the attorney and his blessing, go talk to your banker and lay out the issues. Chances are their banker will pass the info to people higher up at the bank who can actually make a decision. It’s important to understand that their loan officer or relationship manager is probably not the person who makes the decision and often they have no idea what the bank will really do. So, you might get various answers over time, and it will be frustrating.

I’m going to share something about the banking industry many people just don’t understand: Before a loan goes into foreclosure there are 3 stages of delinquency. They are 30-89 days late, 90+ days, and loans on non accrual (loans with no viable way to make payments). As loan moves into later and later categories, banks are forced to set aside more money for expected losses. That money comes right off the profit and loss statement, which most bank executives hate. So, if they let the payment go late 30-60 days they still might not get the bank to the table. After 90 days you should get their attention.

So, if you talk to the bank on the first go around and they are willing to play ball, that’s great. However, if you don’t get the answer you want in 60 days, it’s probably time to let the payment go late. I do not like the idea of burning savings to keep it afloat, so I wouldn’t give the bank a lot of time, as they hope you will keep making payments.

Step 3: Letting the payment go. This part of the process you want to keep your attorney involved in. It might be able to deed the property over to the bank, or do a short sale, and you’ll want your attorney to review any paperwork involved. If however, the bank is willing to play ball at this point, I would request an interest only loan structure for 12 months. That should turn your building cash flow positive for 12 months, and you can rebuild your savings. Also, during the process of letting the payment go, save all the rent and build cash.

My personally opinion is that the commercial real estate market will get worse over the next few years, so getting out of the investment entirely is my preferred strategy. However, every deal is different. One size does not fit all.

Again, see an attorney first, and also share this data to make sure it works for your situation.

California Business Banker

The most important step in the process is the first one. Please do as “California Banker” suggests. Take your loan docs, tax returns, and personal financial statements, and see an attorney that specializes in commercial real estate law, “NOW”.

What neither California Banker nor I know is your personal finance situation, how long you can hold out with negative cash flow, your job status, etc. You need to discuss all of that with someone who knows the laws for your state.

Good Luck.

Mike “Mish” Shedlock

Do you think homedebtors are ready for their California tax bill on forgiven debt? That HELOC will get them.

There’s a fog upon L.A.
And my friends have lost their way
We’ll be over soon they said
Now they’ve lost themselves instead.

As the fog clears over our housing market, those who have lost their debts will find their debts are seeking them.

Patrick.net recently featured this article found on the California Franchise Tax Board’s website: Foreclosures and the next wave: taxes due on canceled debt

… If their lender forecloses on their homes, or accepts an amount less than the loan balance from sale of the home, it may result in taxable gain to the homeowner. The type and treatment of the gain will depend on whether the mortgage is considered non-recourse or recourse debt.

In California, purchase money mortgages, which are mortgages where the borrowed funds are used to purchase the house, are generally treated as non-recourse debt. If the bank forecloses on a non-recourse mortgage, then the homeowner is treated as having sold the home for the amount of the outstanding debt. The difference between the outstanding debt and the homeowner’s adjusted basis in the house is considered a gain or loss on the sale of the home. If the home is the taxpayer’s principal residence, where they have lived for at least two of the past five years, the gain may be eligible for the gain exclusion on the sale of a principal residence. If the foreclosure results in a loss, the loss may not be taken since it resulted from the sale of a principal residence.

With the refinance craze and HELOC boom of the 00s, how many purchase money mortgages exist? In 2006, over 80% of loan originations were refinances; consequently, only the most frugal or those who bought at the peak still have purchase money mortgages. The bulk will be recourse.

If the mortgage is recourse, such as a non-purchase money mortgage or a refinanced mortgage, any foreclosure may result in a gain on the sale of the house, and/or cancellation of debt income. The difference between the fair market value of the house and the homeowner’s adjusted basis will result in a gain or loss on the sale of the home. To the extent the outstanding debt exceeds the fair market value of the house, the amount is treated as cancellation of debt income. Any gain on the portion treated as the sale of a personal residence may be eligible for the exclusion on the sale of a principal residence; however, as discussed above, the loss may not be taken on the sale. The portion that is treated as cancellation of debt income is taxed as ordinary income – subject to ordinary income tax rates. Your clients with canceled or forgiven mortgage debts may receive a Form 1099-C from the lender and will be expected to pay federal and state tax on the canceled amounts, at the ordinary income tax rate.

For example, if the homeowner has a non-recourse mortgage with an outstanding balance of $250,000, and has an adjusted basis of $100,000, the house has a fair market value of $200,000. If the homeowner’s lender foreclosed on the mortgage, the homeowner would have taxable gain of $150,000 ($250,000 less $100,000). If the mortgage had been recourse, the homeowner would have gain on the sale of the home of $100,000 ($200,000 less $100,000), and cancellation of debt income of $50,000 ($250,000 less $200,000).

Many renting-former-owners who have either gone through foreclosure or sold short believe they have no further responsibility to the debt. The lenders are gearing up for collection, but once they give up and begin writing down the debts, they will issue 1099s, and then the State of California will look to collect. This debt is going to linger in one form of collection or another for decades.

Tax on this seemingly “phantom” type of income is due whether the bank forecloses on the mortgage, or allows a “short sale” (allowing the defaulter to sell the house at below cost, and accepting the proceeds as payment in full). A short sale is preferable to a foreclosure only in the sense that it does less damage to the homeowner’s credit rating. The difference between the amount owed to the lender, and the amount received is still considered canceled debt, and taxed at the ordinary income rate. Relief of debt is considered income because the bank gave the buyer cash to purchase the home when it issued the mortgage. This cash was not taxable because it was a loan, and the buyer promised to repay it. When the loan is forgiven or canceled, it becomes income in that year since the buyer will no longer repay it.

You must admit, the logic of the tax position is inescapable. Nobody who took out HELOC money and spent it was thinking about setting aside tax reserves.

There are a couple of options for your clients who are caught in this situation:

• Bankruptcy: Debts discharged in bankruptcies are generally not considered debt-cancellation income.
• Insolvency: Tax will not be assessed on the phantom debt-cancellation income if your client can prove insolvency existed when the debt was discharged. Your client must prove that all assets totaled less than all debts.

If you have clients who have exhausted their options and cannot pay the additional tax on the phantom income they “accrued” through debt cancellation, remember to look into our offer-in-compromise and payment arrangement programs.

You may also want to check out the IRS new Web page devoted to foreclosure tax relief, and related FAQs.

Bankruptcy or insolvency? Those don’t sound like appealing options. Of course, most debtors will claim insolvency and hope they are never asked to prove it, and many, if not most, of those will get away with the deception.

DataQuick News reports California January Home Sales

An estimated 27,858 new and resale houses and condos were sold statewide last month. That was down 33.4 percent from 41,837 in December, and down 5.4 percent from 29,458 for January 2009. A decrease in sales from December to January is normal for the season. California sales for the month of January have varied from a low of 19,145 in 2008 to a peak of 47,137 in 2004, while the average is 32,048. MDA DataQuick’s statistics go back to 1988.

The median price paid for a home last month was $247,000, down 6.4 percent from $264,000 in December, and up 10.3 percent from $224,000 for January a year ago. Because of shifts in market mix, the statewide median always drops from December to January. The January median’s year-over-year increase was the third in a row, following 27 months of year-over-year declines. The median peaked at $484,000 in early 2007 and hit a low of $221,000 last April.

Of the existing homes sold last month, 44.0 percent were properties that had been foreclosed on during the past year. That was up from 40.8 percent in December and down from 58.2 percent in January a year ago. Foreclosure resales peaked at 58.8 percent last February.

ForeclosureRadar released its California Foreclosure Report for January.

With hundreds of thousands of California homeowners in foreclosure a stalemate continues as only a small percentage reach the end of the process through cancellation or sale and the time to foreclose increases.

…

“With delinquent payments rising, foreclosures slowing, and foreclosure alternatives failing,” says Sean O’Toole, Founder and CEO of ForeclosureRadar.com, “it appears the foreclosure crisis will be with us for many years to come”.

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The total number of properties in the foreclosure process remain near record levels in California despite declines in new Notice of Default filings over the last year, largely due to the increase in the time it is taking banks to foreclose, which we cover in a new measure, Time to Foreclose, in this months report. Once Bank Owned (REO) properties are listed for sale they continue to sell quickly, leaving banks with lower than expected inventories.

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We’ve added new measures this month. Time to Foreclose calculates the difference between the date the initial Notice of Default was recorded, and the date the property was sold at trustee sale over time. Time to Foreclose has increased from 146 days in August 2008 to 229 days in January 2010 as lenders have increasingly delayed foreclosures while working through loan modifications and other foreclosure alternatives and moratoriums. We’ve also looked at the average time it takes for properties sold at auction, either Back to Bank or to 3rd Parties, to in turn be resold. At an average 149 days to resell, auction investors are clearly out-performing the bank’s institutional asset managers who have averaged 224 days.

As the NUMMI factory closure looms, we continue to hear more stories of suppliers and service providers closing their doors.

The San Francisco Chronicle reports Nummi suppliers face steep job losses

Already some large, prominent local suppliers have issued official notices of potential layoffs under the state’s Worker Adjustment and Retraining Act. These include Injex Industries, a Hayward maker of molded plastic parts, which issued a notice of the possible loss of 387 jobs. The Livermore site of Johnson Controls has warned that it will eliminate 240 jobs in March and up to 321 jobs in all when its instrument panels and other products no longer find a market in Fremont.

They are among roughly 1,000 companies statewide that supply parts to Nummi, which, since 1984, had been owned by General Motors Corp. and Toyota. But now the mammoth plant visible from Interstate 880 is scheduled to close, as its distressed former parents pare back their own operations.

The number of workers at supplier firms has been estimated from 20,000 to as high as 50,000, a precise count being difficult because so many small shops are involved.

…

It isn’t clear how many supply jobs will be lost as these firms scramble to find work to replace the business they will lose once Toyota quits ordering Corollas and Tacomas from Nummi.

Shortly after government officials held a similar meeting on the Nummi shutdown in November, some 4,700 plant workers directly affected by the closure were declared eligible for special assistance, administered by the Labor Department under the Trade Adjustment Act.

These assists will allow those laid-off Nummi workers to collect unemployment insurance for up to 156 weeks if they need remedial education and take part in state-approved job training programs, along with other benefits.

Now suppliers want to know what sort of assistance they and their workers can expect. Officials from many cities in the Bay Area and Central Valley also expect to suffer from the closure, and major institutions like the Port of Oakland will take a hit when the shipments to and from Nummi cease.

156 weeks of unemployment for NUMMI workers is a LONG time. It’s 3 years.

It sounds like we should be less worried about them and more worried about the thousands of employees of mom-and-pop-type businesses who will close along with the factory.