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Calif. short sale tax break moves forward

 By Brian Bean & Tim Hardin

A bill that would shield some homeowners from paying state income tax after a short sale or foreclosure nudged a little closer to approval last week.

California Assembly Bill 42, which would posthumously extend a tax exemption on qualified debt cancellation on a primary residence, was unanimously reapproved April 29 by the Assembly Revenue and Taxation Committee and sent back to the Appropriations Committee for a May 8 hearing.

A similar bill has already worked it ways through the committee process in the California Senate and awaits budget funding. Senate Bill 30 was unanimously approved in early April and is

now on the Suspense File, where bills are considered after the state budget has been prepared. Budget revisions are due by May 15.

AB 42’s approval can’t come too soon for California homeowners preparing to complete a short sale, or for those who may already have closed one this year.

“This bill will prevent undue hardship to taxpayers who would otherwise be subject to taxation resulting from having all of part of their loan balance on their principal residence forgiven by the lender,” Assemblyman Henry T. Perea, D-Fresno, the bill’s author, said in a release. “A lot of families who are forced to make a decision to sell their home, as a short sale, are already in financial trouble. They can’t afford to pay an additional tax on money they’ve never received.”

Perea introduced AB 42 on Dec. 7, 2012, to extend the terms of the Conformity Act of 2010 through the end of 2013. That law – and the federal Mortgage Forgiveness Debt Relief Act of 2007 – expired Dec. 31 last year.

On Jan. 2, Congress approved “fiscal cliff” legislation that, among other things, extended the federal tax protection through 2013.

WHAT’S THE BIG DEAL?

Banks claim their losses to the Internal Revenue Service as debt cancellation and send consumers IRS 1099 forms, which must be reported on tax returns. After a short sale or foreclosure, California taxpayers could owe as much as $1,000 to $12,300 in taxes on a $100,000 loss to the bank, depending upon income level.

The proposed state law would shield some homeowners from paying those taxes.

Terms of the proposed California bills:

 -- Tax forgiveness would only be available for debt cancellation between Jan. 1, 2007, and Dec. 31, 2013, possibly through short sale, foreclosure or loan modification.

-- Taxpayers could only exclude up to $500,000 of actual debt cancellation ($250,000 if married filing separately).

-- The tax exclusion would be limited to loans up to $800,000 ($400,000 if married filing separately)

 -- Debt could only be forgiven on a qualified principal residence. Second homes and income properties would not qualify.

 -- Tax forgiveness would be limited to debt used to “buy, build or substantially improve” a principal residence. If an owner refinanced the home and took out cash to remodel the home, it might be covered. Cash out to pay other bills or make purchases would not qualify, however.

If lawmakers fail to extend the state law, homeowners who missed last year’s deadline face unexpected tax bills. Some homeowners, however, may have backup plans.

‘INSOLVENCY’

Taxpayers who are “insolvent” may be exempt from paying income taxes on all or part of the debt cancellation from a short sale or foreclosure.

The IRS insolvency calculations, and the rules, are complex. The tax forms must be completed by a tax preparer, preferably an expert with lots of experience in this field, or a tax attorney.

(Need a referral to local tax professionals? Call us today at 951-778-9700 and we’ll provide you contact information.)

BANKRUPTCY

In some cases, bankruptcy can wipe out consumer debt and the tax liability. But bankruptcy is like dropping an atom bomb on a credit report – it shouldn’t be taken lightly.

Talk to a trusted, experienced attorney for guidance on your specific situation, before the bank takes action.

(Need a referral to a local bankruptcy attorney? Call us today at 951-778-9700 for a good contact.)

KNOW YOUR OPTIONS

AB 42’s approval would surely ease the pressure on qualified distressed homeowners. But it would not eliminate it. An extension would only push the deadline one more year.

Loan modifications and short sales can take months, and the timelines are likely to stretch as homeowners rush to beat the deadlines. Many home sellers who were scheduled to close short sales at the end of 2012 missed the deadline because of the end-of-year rush, and are still waiting nervously for the state tax bill to be approved.

The likelihood of Congress again extending the federal legislation is low. Anyone facing the same situation this year must plan ahead or risk a massive tax bill next year.

Are you qualified for the existing tax exemptions? Call us today at 951-778-9700 and we’ll do the research for you.