California Short Sale Tax Liability Update

I would be remiss if I did not include the following disclaimer prior to diving into this issue:

REALTORS® should encourage their clients to seek the advice of a tax professional regarding the tax consequences of a short sale.

As most of you know, SB 401 which extended the income tax debt forgiveness on short sales in California (conforming state tax code to federal tax code) expired at the end of 2012. At that same time, Congress passed budget resolutions to avoid the "fiscal cliff," which included an extension of the mortgage debt forgiveness sunset date (federal tax law) to January 1, 2014.

This year, C.A.R. sponsored SB 30 that would once again conform the state tax law to the federal law, extending mortgage debt forgiveness through January 1, 2014. Unfortunately, SB 30 met extensive political scheming which ultimately led to its demise in the legislature this year.

So what does all of this mean for short sales which occurred (or are occurring) in California in 2013? Good question.

There are efforts underway to see SB 30 (or similar legislation) enacted prior to April 14, 2014 with a retroactive provision back to January 1, 2013. This would essentially conform (retroactively) the CA State tax law with the Federal law for tax year 2013.

Regardless of what happens with the state mortgage debt forgiveness extension, it's important to remember that the Federal mortgage debt forgiveness provision sunsets on January 1, 2014, meaning the "forgiveness" of mortgage debt will subside at the end of this calendar year.

Having said that, there is a potential caveat to this entire process which has many (including myself) raising a brow in cautious optimism.

Per a recent letter from the Internal Revenue Service, (IRS) "A short sale in California is generally not subject to federal income tax for mortgage debt forgiveness." This determination has the potential to set the stage for a long term fix for short sale transactions in California and could potentially alleviate the need for additional legislation to address this issue.
The California Association of REALTORS® (C.A.R.) worked closely with Senator Barbara Boxer to obtain this IRS guidance and there is now hope that similar guidance can be given from the California Franchise Tax Board (FTB) to address state income tax for mortgage debt relief income.

Given that a homeowner in California generally cannot be held personally liable for a short sale deficiency, 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.

Stay tuned, I will keep you posted as this issue develops.

...again, REALTORS® should encourage their clients to seek the advice of a tax professional regarding the tax consequences of a short sale.