Two weeks ago CBS ran a 1 hour special about California foreclosures and short sales and they talked about the fact that our state tax code does not conform to HR 3648 and that Californians who do short sales will very likely have to pay state income tax on the income / losses the lender suffers. As an agent in the trenches, I have received numerous emails and phone calls about this issue. Please see actual email from one of my clients below:
Hi Jacob,
I just saw on the channel 2 news that the state of California charges taxes on the short sale difference even though the federal government does not. They said that the waiving of that fee in California expired last year. The showed an example of someone owing 13K in taxes. Is this true? Please let us know.
Thank you,
(My Response)
Hi ______,
It's Jacob here. That Channel 2 special has created quite the stir. Yes it is true that in California (and only here), our state tax code does not conform to the guidelines set forth in HR 3648 (Mortgage Foregivness Debt Relief Act of 2007). After Jan 2009, all short sales and foreclosures may be subject to a state tax. (up to 9.3% in excessive cases) There is pending legislation to change this... such as SB97 and AB 111. As you know, we cannot give tax advice. I recommend that you ask your CPA if you would qualify for any relief (as many people do) from IRS Section 121 since it is your primary residence, or IRS Section 108...the insolvency clause. I have included an excerpt from a reputable source...but please do not rely on this as tax advice. Let's stay in touch about this issue.
Article:
Generally, when there is either a foreclosure or a short sale a taxpayer will receive either (in some cases the lender may issue both) a federal Form 1099-A, Acquisition or Abandonment of Secured Property, or Form 1099-C, Cancellation of Debt, that provide the amount of debt cancelled, information to compute gain or loss, and whether the taxpayer is personally liable for the debt.
If you borrow money from a commercial or private lender and the lender later cancels or forgives the debt, you may have to include the canceled amount in income for tax purposes, depending on the circumstances. In a short sale, the lender agrees to accept less than full payment, and cancels the unpaid amount.
The most common situations when a foreclosure or a short sale does not result in cancellation of debt (COD) income involve a non-recourse loan. A non-recourse loan means the lender’s only remedy in case of default is to repossess the property the lender cannot pursue you personally in case of default. A purchase money loan (that is, a loan taken to “purchase” your home) is generally considered to be a non-recourse loan in California. Refinances, second mortgages, and “cash out” loans are generally recourse loans.
Although forgiveness of a non-recourse loan resulting from either a foreclosure or a short sale does not result in COD income, it may result in other tax consequences, like a reportable gain from the disposition. Even if the debt discharged is non-recourse, a taxpayer may have a gain to the extent the balance of the mortgage forgiven exceeds their adjusted basis of the property.
The gain, if any, from the foreclosure or short sale may or may not be taxable, depending on whether IRC section 121 applies and the amount of the gain. IRC section 121 only applies to principal residences, and limits the amount of gain that can be excluded from income.
If the loan is a recourse loan, then depending on the facts, you may have COD income, and potentially a reportable gain, in which case you would want to determine if one of the provisions in IRC section 108 would apply, allowing the COD income from the discharge of indebtedness to be excluded.
For 2007 and 2008, California conformed, with modifications to IRC section 108 (a)(1) (E) that allows a limited amount of COD income resulting from the foreclosure or short sale of a qualified principal residence to be excluded. However, this exclusion is currently not allowable for any foreclosure or short sale that occurs on or after January 1, 2009. (Note: There is pending legislation that would extend the California exclusion, SB 97 and AB 111.) One of the provisions available in IRC section 108 that might apply is the insolvency rule, which would apply if a taxpayer has COD income and is insolvent (total liabilities exceed total assets); in that case, the exclusion only applies up to the amount of insolvency, (to the extent, liabilities exceed assets).
More information regarding foreclosures and short sales is available at irs.gov. In particular, you may want to refer to the IRS webpage titled “Home Foreclosures and Cancellations”
If your reporting position is audited by California, you should be prepared to provide documentation and an analysis of your facts in support of your position.
If you borrow money from a commercial or private lender and the lender later cancels or forgives the debt, you may have to include the canceled amount in income for tax purposes, depending on the circumstances. In a short sale, the lender agrees to accept less than full payment, and cancels the unpaid amount.
The most common situations when a foreclosure or a short sale does not result in cancellation of debt (COD) income involve a non-recourse loan. A non-recourse loan means the lender’s only remedy in case of default is to repossess the property the lender cannot pursue you personally in case of default. A purchase money loan (that is, a loan taken to “purchase” your home) is generally considered to be a non-recourse loan in California. Refinances, second mortgages, and “cash out” loans are generally recourse loans.
Although forgiveness of a non-recourse loan resulting from either a foreclosure or a short sale does not result in COD income, it may result in other tax consequences, like a reportable gain from the disposition. Even if the debt discharged is non-recourse, a taxpayer may have a gain to the extent the balance of the mortgage forgiven exceeds their adjusted basis of the property.
The gain, if any, from the foreclosure or short sale may or may not be taxable, depending on whether IRC section 121 applies and the amount of the gain. IRC section 121 only applies to principal residences, and limits the amount of gain that can be excluded from income.
If the loan is a recourse loan, then depending on the facts, you may have COD income, and potentially a reportable gain, in which case you would want to determine if one of the provisions in IRC section 108 would apply, allowing the COD income from the discharge of indebtedness to be excluded.
For 2007 and 2008, California conformed, with modifications to IRC section 108 (a)(1) (E) that allows a limited amount of COD income resulting from the foreclosure or short sale of a qualified principal residence to be excluded. However, this exclusion is currently not allowable for any foreclosure or short sale that occurs on or after January 1, 2009. (Note: There is pending legislation that would extend the California exclusion, SB 97 and AB 111.) One of the provisions available in IRC section 108 that might apply is the insolvency rule, which would apply if a taxpayer has COD income and is insolvent (total liabilities exceed total assets); in that case, the exclusion only applies up to the amount of insolvency, (to the extent, liabilities exceed assets).
More information regarding foreclosures and short sales is available at irs.gov. In particular, you may want to refer to the IRS webpage titled “Home Foreclosures and Cancellations”
If your reporting position is audited by California, you should be prepared to provide documentation and an analysis of your facts in support of your position.
Anyone else being asked about this issue?
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