OVERVIEW OF THE LAW:
Income Tax Liability. Under Federal tax code, all forgiven debt under a mortgage is considered taxable income. The 2007 Debt Forgiveness Act was created to eliminate that federal tax for qualifying persons who short-sold, foreclosed, or negotiated a reduced principal on their primary residence. California passed a similar law at that time. Today, the 2007 Federal Debt Forgiveness Act has expired and California has stopped offering its equivalent tax relief as of last year. Result: Generally, a person would have to pay State and Federal taxes on their forgiven debt resulting from a short sale or foreclosure.
Repayment of Debt from Recourse Loan. In 2011, California enacted CA Code of Civil Procedure Section 580(e) which provided that a borrower is not required to repay the balance of a mortgage resulting from a short-sale regardless of what a loan contract might say, effectively transforming all recourse loans into non-recourse loans for short-sales only; this law applied to dwelling homes of four units or less. Note that this statute, of course, has nothing to do with tax liability, only liability to repay the indebtedness.
CA Homeowner Liabilities in 2012. During the time when the 2007 Federal Debt Forgiveness Act and California equivalent were still in effect, CCP 580(e) [regarding loan repayment] coupled with the Debt Forgiveness Acts [regarding tax liability] meant all Californians short-selling their personal residence had no liability whatsoever for both repayment loan balance after short-sale AND debt forgiveness income taxes at both the State and Federal level.
CHANGES FOR 2014:
Changes for Borrowers in 2014. With both debt forgiveness acts no longer in effect, the question for homeowners today is whether or not there is some other "excuse" (or exception) to not pay taxes on the forgiven debt. This question must be addressed in two parts, both federally and at the State level.
A. Federal Tax: Generally, a person would have to pay income tax on the debt forgiven absent an exception. One exception to paying debt forgiveness tax at the federal level applies to persons who prove insolvency at the time the debt was forgiven (i.e. all assets were less than all debt). This threshold is difficult to meet and, therefore, such exception is not always available to borrowers. However, in a recent opinion from the IRS (recent as in 6 months ago), the IRS stated that it will consider for tax purposes all debt forgiveness under CA CCP 580(e) as an exception to paying federal debt forgiveness income tax. This is great news for some Californians!
B. CA Tax: As stated previously, CA had stopped offering its equivalent debt forgiveness tax relief more than one year ago. However, just a few weeks ago, the State Board of Equalization (CA IRS) ruled that it would follow Federal opinion and consider short-sales subject to CCP 508(e) exempt from CA debt forgiveness tax. More great news for Californians!
CONCLUSION:
With the very recent tax developments, it is clear that the best choice for Californians considering a foreclosure may be to short-sell their property. However, it is important to speak with your tax professional about specific consequences before making any decision. If you wish to talk to an informed real estate salesperson about short-selling your home, contact Land Catchers Investments today at 916-932-7336!
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