The following article was published today by REALEGAL through C.A.R. (California Association of Realtors) correspondence. It is clarification about taxes on short sales for California residents.
NO FEDERAL DEBT RELIEF INCOME TAX FOR SHORT SALES
A short sale in California is generally not subject to federal income tax for mortgage debt forgiveness, according to a recent letter from the Internal Revenue Service (IRS). C.A.R. worked closely with Senator Barbara Boxer to obtain this IRS guidance. We are also hopeful that we can promptly obtain similar guidance regarding state income tax for mortgage debt relief income from the California Franchise Tax Board (FTB), which has been awaiting this IRS letter.
Given that a homeowner in California generally cannot be held personally liable for a short sale deficiency (see below), the IRS stated in its letter that it would consider the mortgage loan as a nonrecourse obligation that is not subject to federal debt relief income tax. The amount of indebtedness, however, must be reported as the amount realized for capital gains purposes. Of course, a principal residence is generally excluded from capital gains tax up to $250,000 for single taxpayers and $500,000 for married couples filing joint returns (under 26 U.S.C. § 121).
As background, California law generally protects a borrower from owing a deficiency after a short sale of a residential property with one-to-four units, including both first and junior trust deeds (Cal. Code of Civ. Proc. section 580e). Exceptions include fraud, waste, cross-collateralized loan, and a borrower that is a corporation, LLC, or limited partnership. For more information, see C.A.R.’s legal article on Short Sale Deficiencies.
Although short sale sellers of a qualified principal residence are currently protected against federal debt relief income tax under the Mortgage Forgiveness Debt Relief Act of 2007, that federal law is set to expire on December 31, 2013, whereas the tax exemption set forth in the IRS letter has no expiration date. Similar protection to the federal Mortgage Forgiveness Debt Relief Act for state income tax under California law has already expired on December 31, 2012. However, other exemptions from federal and state taxation of debt relief income are available, such as for bankruptcies and insolvencies. REALTORS® should encourage their clients to seek the advice of a tax professional regarding the tax consequences of a short sale.