Considering selling your home as a short sale or have you started the process? You will want to know the consequences regarding the amount forgiven by your lender(s). Federal law has extended the forgiveness of tax liability; however, as of this writing, California tax law extension is pending. For those of you outside the state of California, it is imperative you contact your local experts regarding the short sale of houses and debt forgiveness.
With real estate values on the rise, you’re probably thinking you will be okay and your home will have equity shortly. Not so fast! I suggest you have your specific situation evaluated by a qualified short sale agent expert to calculate your home and all the trends for your area.
As always, I recommend seeking out a qualified CPA accountant familiar with these laws. For any further questions or help regarding this issue, feel free to contact me.
What are the tax implications of a short sale?
A. Cancellation of Debt (COD) Income
A short sale, where the lender agrees to reduce some or all of the outstanding debt, may give rise to forgiveness of debt income (also called cancellation of debt” or COD income). The amount of the debt that the lender agrees to write off is treated as “ordinary income” (as opposed to capital gains income, which is taxed at a lower rate). Even though the lender may be taking this action to facilitate the sale by the owner who is under a notice of default and facing a foreclosure, the agreement between the owner and the lender is considered voluntary and the amount of the loan written off by the lender is treated as forgiveness of debt (cancellation of debt – COD). The taxpayer will generally receive a 1099 tax form from the lender in the amount of the cancellation of debt.
This forgiveness or cancellation of debt which is treated as “ordinary income” under certain circumstances may or may not be subject to taxation.
Federal Mortgage Forgiveness Debt Relief
Under the Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648) signed by President Bush on December 20, 2007, Internal Revenue Code §108(a)(1)(E) was added and provides that a taxpayer will not be taxed upon cancellation of debt income if the following conditions are met:
- The property sold in the short sale is the taxpayer’s principal residence, as that term is used in IRC §121.
- The cancellation of debt is Qualified Principal Residence Indebtedness** under IRC Section 163(h)(3)(B).
- The indebtedness is discharged after January 1, 2007 and before January 1, 2014. (The end date was increased by three years from 2010 to 2013 pursuant to H.R. 1424, the Emergency Economic Stabilization Act of 2008 and extended to 2014 by H.R. 8, American Taxpayer Relief Act of 2012 signed into law January 2, 2013 by President Obama).
**Qualified Principal Residence Indebtedness is a loan secured by the residence used to acquire, construct or substantially improve the residence. The income relief provided is capped at $1,000,000 in the case of a married person filing a separate return and $2,000,000 for all others.
Any reduction of indebtedness excluded by IRC §108(a)(1)(E) will be applied to reduce the basis of the taxpayer’s principal residence, but not below zero. This could result in a higher amount of capital gains tax owed by the taxpayer.
California Mortgage Debt Forgiveness Relief
California law, SB 401, conforms California Revenue and Tax Code Section 17144.5 to federal law, but with the following changes:
(1) The maximum amount of qualified principal residence indebtedness is $800,000 for married couples filing jointly, registered domestic partners filing jointly, single persons, head of household, widow/widower; and $400,000 for married couples or registered domestic partners filing separately; and
(2) The maximum amount of debt relief income that can be forgiven is $500,000 for married couples filing jointly, registered domestic partners filing jointly, single persons, head of household, widow/widower; and $250,000 for married couples or registered domestic partners filing separately; and
(3) California’s debt relief statute applies to property sold on or after Jan. 1, 2009 and before Jan. 1, 2013.
California has not currently passed a law which extends the California debt relief statute to bring it into conformity with the federal law which extended the federal debt relief statute to January 1, 2014 (see above). C.A.R. has sponsored SB 30 (Calderon, D-Montebello) to extend California’s debt relief protections which are currently pending. The proposed law would be effective retroactive to January 1, 2013. Information on the status of the bill can be found at www.leginfo.ca.gov.