If you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes, depending on the circumstances. When you borrowed the money you were not required to include the loan proceeds in income because you had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount you received as loan proceeds is normally reportable as income because you no longer have an obligation to repay the lender. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt. For Federal tax purposes, in many instances the debt forgiven on principal residences may be excluded from taxable income. This was discussed by me in a separate blog entry at Debt Forgiveness – Taxable Income for Federal Tax Purposes?.

California Revenue and Tax Code Section 17144.5generally conforms with federal law, the Mortgage Forgiveness Debt Relief Act of 2007,for residential recourse loans with the following exceptions for tax years 2007 and 2008:

(1) The maximum amount of acquisition indebtedness is reduced to $800,000 for couples filing jointly and $400,000 for individual filers;

(2) The maximum amount of debt relief income that can be forgiven is $250,000 for couples filing jointly and $125,000 for individual filers; and

For tax years 2009=2012, the limits for California are as follows:

  • Limits the amount of qualified principal residence indebtedness to $800,000 for taxpayers who file as married/registered domestic partners (RDP) filing jointly, single, head of household, or widow/widower, and to $400,000 for taxpayers who file as married/RDP filing separately.
  • Limits debt relief to $500,000 for taxpayers who file as married/RDP filing jointly, single, head of household, or widow/widower, and to $250,000 for taxpayers who file as married/RDP filing separately.

  • California’s debt relief statute applies to property sold on or after January 1, 2007 and before January 1, 2013. See California Legislature passes Debt Forgiveness Tax Relief

    In California, purchase money home loans are considered nonrecourse because lenders are prohibited from seeking a deficiency judgment against the borrower after a foreclosure sale of real property that secures a purchase money loan. CCP §580. ( The requirements for a purchase money mortgage are discussed in my blog entry Short Sales and California Anti-Deficiency Laws ). A loan is nonrecourse if the lender’s only remedy in case of default is to repossess the secured property (because the lender cannot reach the borrower’s other assets to satisfy any shortfall). Under these circumstances, the unpaid principal balance of the mortgage is not seen as being “forgiven” or “cancelled” and does not cause the borrower to have cancellation of indebtedness income. Treas Reg §1.1001-2(a)(4)(i) and (c), Examples 7-8; IRS Letter Ruling 9302001. Thus,there would be no debt foregiveness in Californiafor foreclosure properties for those whohad used purchase money indebtedness to acquire or substantially improve a principal residence. Such homeowners would not have cancellation of indebtedness income to exclude because their loans were considered nonrecourse in the first place. ( Source: http://ceb.com/lawalerts/reflectionsloanforeclosures.asp?WT.mc_id=la_4415 Continuig Education of the Bar website ).

    The following comes from the California Franchise Tax Board website relating to taxation of foreclosed property and also applys to short sales:

    “If the bank forecloses on a non-recourse mortgage, then the homeowner is treated as having sold the home for the amount of the outstanding debt. The difference between the outstanding debt and the homeowner’s adjusted basis in the house is considered a gain or loss on the sale of the home. If the home is the taxpayer’s principal residence, where they have lived for at least two of the past five years, the gain may be eligible for the gain exclusion on the sale of a principal residence. If the foreclosure results in a loss, the loss may not be taken since it resulted from the sale of a principal residence.”

    “Although forgiveness of a non-recourse loan resulting from either a foreclosure or a short sale does not result in COD ( Cancelation of Debt ) income, it may result in other tax consequences, like a reportable gain from the disposition.”

    “If the mortgage is recourse, such as a non-purchase money mortgage or a refinanced mortgage, any foreclosure may result in a gain on the sale of the house, and/or cancellation of debt income. The difference between the fair market value of the house and the homeowner’s adjusted basis will result in a gain or loss on the sale of the home. To the extent the outstanding debt exceeds the fair market value of the house, the amount is treated as cancellation of debt income. Any gain on the portion treated as the sale of a personal residence may be eligible for the exclusion on the sale of a principal residence; however, as discussed above, the loss may not be taken on the sale. The portion that is treated as cancellation of debt income is taxed as ordinary income – subject to ordinary income tax rates. “

    “If the loan is a recourse loan, then depending on the facts, you may have COD income, and potentially a reportable gain”.

    For a short sale, either for a recourse or non-recourse loan, the gain on sale would, of course, be based on the sales price of the loan.

    A seller of a short sale property could be “insolvent” for tax purposes, i.e., overall debts exceed assets at the time the cancellation of debt income is realized. When a taxpayer is “insolvent,” under both state and federal law, the tax liability for the cancellation of debt could be limited or eliminated. See How to use the Insolvency Exclusion from Debt Forgiveness Tax

    For more information about income taxes and real estate, see Income Tax Issues .

    **NOTE: The information contained at this site is for educational purposes only , and although believed to be accurate, itis not intended for any particular person or circumstance. A competent tax professional should always be consulted to verify the information presented and before utilizing any of the information contained at this site.**

    For more information about Palos Verdes and South Bay Real Estate and buying and sellinga homeon the Palos Verdes Peninsula, visit my website at https://www.maureenmegowan.com. I try to make this the best real estate web blog in the South Bay Los Angeles and the Palos Verdes Peninsula.I would love to hear your comments or suggestions.