2nd Mortgage Debt Forgiven, Judgement?

Real Estate Investing Real Estate Law
1

Hi Everyone,

I am buying a short sale in Snohomish County Washington State. There is a $278k 1st and a $40k 2nd. The homeowners moved out 2 years ago, and lived there for a number of years up to that point.

I am concerned over two things:

  1. forgiven debt from the short of either the 1st or 2nd could result in taxable income to the sellers. Is forgiven debt handled differently for either a 1st or 2nd taxable wise? Does it come down to the random chance of whether or not the bank sends them a 1099? I believe it is correct to assume the 1st is a non-recourse loan and the 2nd is a recourse loan?

  2. Washington is a deed of trust state, so there are non-judicial foreclosures and therefore, no deficiency judgments for 1st mortgage (non-recourse loans) however, there may be a judgement for second mortgages (recourse loan), either after a foreclosure, when they are wiped away as a junior lien, or when settled for less than what is owed.

I do not want to get the 1st mortgage and second mortgagee to settle for less than what is owed if it will expose the seller to the difference. If the mortgagee signs a “full release” during the short, does it fully protect the seller? Can the 1st come after the seller for the difference also?

I welcome input anyone may have.

Thanks,

Will

2

If the seller was “insolvent” at the time of the short sale of the 1st or 2nd, they are not liable for any “income” from the forgiveness of debt. If the file chapter 7 bankruptcy they are insolvent by definition. But if they can show on paper they were insolvent at the time of the short, they owe no tax. Look at IRS form 982.