Deed in Lieu of Foreclosure: WA Real Estate Excise Tax

In Washington State, Real Estate Excise Tax (REET) applies to most transfers of Real Property. One exception to this general rule is when a purchaser gives the bank a Deed in Lieu of Foreclosure.

WAC 458-61A-208(3) provides that the REET does not apply to the following transfers where no additional consideration passes:

(a) A transfer by deed in lieu of foreclosure to satisfy a mortgage or deed of trust;

(b) A transfer from a contract purchaser to the contract holder in lieu of forfeiture of a contract of sale upon default of the underlying obligation; or

(c) A transfer occurring through the cancellation or forfeiture of a vendee's interest in a contract for the sale of real property, regardless of whether the contract contains a forfeiture clause, such as a declaration of forfeiture made under the provisions of RCW 61.30.070.

Therefore, when a "deed in lieu" of foreclosure is given back to the bank in a deed of trust situation, no REET is owed on the transaction. However, this is only the case when there is no additional money paid or other consideration given. This means that if, as a condition of accepting the "deed in lieu," the Bank requires the homeowner to pay additional money (or sign a new promissory note etc.) REET will apply to the sale.

Short Sales: Other Options That May be Available

In addition to a formal short sale, a homeowner may be able to pursue other alternative courses of action other than short sale or foreclosure.

Loan Modification: In certain circumstances, the lender may agree to change the terms of the original loan to make the payments more affordable to the homeowner. The interest rate may be lowered or the loan term extended, and missed payments may be allowed to be added to the existing loan balance. The specific terms of a loan modification will be determined by the negotiation between the homeowner and the lender.

Loan Workout: A homeowner that falls behind on payments may have the ability to enter into a repayment plan, forbearance agreement or other payment structure to get the homeowner back on track with monthly payments.

Deed-in-Lieu of Foreclosure: A lender may allow the homeowner to "give back" the property to the lender. Care must be taken by the homeowner to verify that the lender will be prevented from seeking a deficiency after the transactions occurs.

Conclusion: Each alternative contains its own benefits and risks. A homeowner should consult competent professional advice to assess the homeowner's situation and available options.

Short Sales: Basis Implications

A discharge of indebtedness under § 108(a)(1)(E) (for more info check here) will reduce the seller’s tax basis in his house (but not below zero),  and therefore may result in the seller having a greater capital gain on the sale of his property.  See IRC § 108(h)(1).  This capital gain may, however, be excluded under the § 121 rules that exclude gain from the sale of a principal residence.  No loss deduction is allowed on a short sale of a personal residence because personal property losses are only allowed for losses arising from fire, storm, casualty or theft.  The exclusion (§ 108(a)(1)(E)) is claimed by filling out a Form 982 Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment) which is attached to the taxpayer’s tax return.  Any person that is considering a short sale should seek competent professional advice to determine whether or not the § 108(a)(1)(E) exclusion applies and what other basis implications and capital gain implications exist. 

Short Sales: General Tax considerations.

Generally, if a bank forgives a debt (e.g. the short seller’s deficiency amount), the debt forgiveness constitutes “cancellation of debt” (COD) income under IRC § 61(a)(12).  Under that section COD income is taxable income which will be reported on the taxpayer’s 1040 form.  This general rule, however, may not apply in short sale situations.  Per IRC § 108(a)(1)(E), a taxpayer does not have to include COD income when the discharged indebtedness constitutes “qualified principal residence” indebtedness discharged from January 1, 2007 and January 1, 2013. 

Qualified principal residence indebtedness means acquisition indebtedness as defined under IRC § 163(h)(3)(B).  Generally, this means debt that was incurred in acquiring, constructing, or substantially improving the taxpayer’s principal residence and is secured by the residence.  See generally § 108(h) and § 163(h)(3)(B).  Note that this definition does not include all types of debt on a home, specifically refinance debt and second mortgage situations, and the taxpayer needs to verify that their situation falls within all of the statutory definitions of “qualified principal residence” and “acquisition indebtedness.”  A seller that is considering selling his house short should verify the tax implications of the short sale with a competent advisor prior to entering into any agreement to sell the house.    

Short Sales: What is a deficiency in a short sale?

A deficiency in a short sale is the difference between the net sale proceeds of the house and the outstanding loan balance owed on the house.  As an example:

Net home sale proceeds	$200,000.00
1st deed of trust balance owed at time of sale	($240,000.00)
Seller’s deficiency	($40,000.00)

In a short sale, when the seller’s bank chooses to release its deed of trust, it may either (1) demand that the seller personally cover the deficiency (and the seller will still be responsible to pay back the deficiency), or (2) may agree with the seller that the bank will not pursue the seller for a balance owed on the deficiency.  Therefore, in the example, if the seller does not want to be on the hook for the $40,000.00 deficiency then he must obtain the bank’s written agreement that he will be released from owing the deficiency.  The seller should seek professional advice to verify that the agreement is binding on the bank and make sure that his interests are protected.