California Income Taxes for Short Sales, Loan Mods and Foreclosures

Debt Forgiveness – Federal and California Tax Issues

For most states, other than California as explained below, 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.The amount of debt forgiven must be reported on Form 982 and this form must be attached to your tax return

The Mortgage Debt Relief Act of 2007, however, generally allowed taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief. This provision applies to debt forgiven in calendar years 2007 through 2012. This was extended by Congress to 12/31/2013, but has not yet been extended past 2013. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion does not apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.

For California purposes, this exposes some taxpayers to debt foregiveness income for foreclosure properties and loan modifications, but in most instances will not result in debt foregiveness income for residential short sales as explained below.

The Act applies only to forgiven or cancelled debt used to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes. In addition, the debt must be secured by the home. This is known as qualified principal residence. If you refinanced, the debt is eligible but only up to the extent that the principal balance of the old mortgage, immediately before the refinancing, would have qualified. If you take out additional equity, that debt does not qualify for this exclusion.For instance, home equity lines of credit must have been used to make improvements to the home, and if used to buy a car would not qualify.

If the debt forgiven is not for your personal residence, the forgiven debt may qualify under the insolvency exclusion. Normally, you are not required to include forgiven debts in income to the extent that you are insolvent. You are insolvent when your total liabilities exceed your total assets. The forgiven debt may also qualify for exclusion if the debt was discharged in a Title 11 bankruptcy proceeding or if the debt is qualified farm indebtedness or qualified real property business indebtedness. If you believe you qualify for any of these exceptions, see the instructions for Form 982. Publication 4681 discusses each of these exceptions and includes examples.

• California law generally conformed with federal law, the Mortgage Forgiveness Debt Relief Act of 2007, with the following exceptions:

  (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 $500,000 for couples filing jointly and $250,000 for individual filers; and

  (3) California’s debt relief statute applies to property sold on or after January 1, 2007 and before January 1, 2013. It was not extended when Congress extended the Federal tax act to 12/31/2013. This therefore exposes some California taxpayers to debt foregiveness income for foreclosures, but California taxpayers are generally not exposed to debt foregiveness income for short sales as noted below.

• California Short Sales: Section 580e of the California Code of Civil Procedure also addresses mortgages. This section was added in 2010 and it prohibits a deficiency judgment on specific agreed to “short sales” (allowing the defaulter to sell the house at below cost, and the lender accepting the proceeds as payment in full). In 2011, section 580e was amended to expand its provisions in order to mitigate the impact of the ongoing foreclosure crisis and to encourage the approval of short sales as an alternative to foreclosure. This relates only to principal residences.

  According to an IRS Information Letter dated September 19, 2013, the IRS has determined under the 2011 changes to the California Code of Civil Procedure Section 580e, that California taxpayers who sell their principal residences in a short sale for less than what is owed on the home are relieved of incurring cancellation of indebtedness income, if the lender agrees to the short sale as full consideration of the mortgage debt, and there will be no cancellation of indebtedness income.

  The IRS€™s letter answered the question regarding whether a homeowner would have taxable cancellation of indebtedness (COD) income when the lender approved a short sale considering California€™s Code of Civil Procedure (CCP) section 580e. The letter finds California€™s anti-deficiency provision under section 580e of the CCP which generally prohibits a lender who holds a deed of trust from either claiming a deficiency or obtaining a deficiency judgment from the homeowner after agreeing to a short sale, treats the homeowner€™s obligation as a nonrecourse obligation for tax purposes.

  This means in California, upon a lender€™s acceptance of the short sale any CCP 580e qualifying cancellation of indebtedness income is nontaxable nonrecourse debt. CCP 580e does not apply to all short sales. In addition to other restrictions this law states it does not apply if the trustor or mortgagor is a corporation, limited liability company, limited partnership, or political subdivision of the state.

  California conforms to the relevant portions of the federal tax law governing the forgiveness of nonrecourse and recourse debt, so if the lender agrees to the short sale as full consideration of the mortgage debt, for tax purposes, the loan will be nonrecourse thus, there is no cancellation of indebtedness income for California tax purposes.

  
  California Foreclosures:

  In California, for foreclosure purposes, purchase money home loans used to initially acquire a home 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. A subsequent refinancing of the loan would result in its not being a purchase money mortgage and would be a recourse debt. 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 California for those who had 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.

• For foreclosures, The following comes from the California Franchise Tax Board website :

  “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”.

  The above rules generally apply to reductions in loan balances for loan modifications as well. Effective January 1, 2013,however, a refinancing for a California dwelling for not more than four families occupied entirely or in part by the purchaser will still be nonrecourse for the portion of the loan principal refinanced that was a purchase money mortgage.It is not clear, however, if this would be effective for subsequent refinancings.
  In California, therefore, there are significant tax advantages to complete a short sale versus losing a property through foreclosure. Make sure and consult with your own tax accountant or attorney when making this decision.

  A seller of a short sale property or a foreclosure sale 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 further information on other tax issues relating to foreclosures and short sales including both calculation of gain or loss as well as debt forgiveness issues , see the excellent article Tax Consequences of a “Short Sale” of Real Estate vs. Foreclosure

• The above information is provided for educational purposes only and each taxpayer should consult their own tax accountant or attorney to determine it’s accuracy and relevance to the taxpayers unique circumstances.