Possible Consequences of Short Sales for Californians--It's good to be informed!

This article was emailed to me and it is definitely worth a read if you are in the process of selling your home short sale or if you are contemplating listing your home for sale at a short sale price (selling your home for less than you owe the bank). 

It is better to be informed of all the ramifications than to bury your head in the sand and hope it all works out.  Please forward this to anyone who may find it helpful for their situation. 

Subject:  Short Sale -- tax hit on CA properties - FYI
 
Tara Blackwell and her husband sold their Fairfield house in December for about half of its original $825,000 price as a short sale, in which the bank agrees to accept less than is owed on the mortgage.
The couple and their two children moved in with Blackwell's parents and thought the situation was behind them. Then it came time to pay their 2009 taxes.


To their dismay, they discovered that California would count the $412,000 difference between their original price and the sale price as part of their income, resulting in a hefty state income tax bill.


"We lost our down payment of $70,000, we lost our home and now California wants $38,000 (in extra taxes) from us," Tara Blackwell said. "It's like kicking you when you're down."


California legislators last week passed a bill that would fix the situation. It mirrors a federal law that excludes "forgiven debt" on a principal residence from being considered taxable income. It covers short sales, foreclosures, deeds in lieu of foreclosure and loan modifications that reduce the principal due.
However, Gov. Arnold Schwarzenegger, who has until March 23 to sign the bill, indicated that he is likely to veto it based on an unrelated provision regarding tax fraud.


"It was a shock to me to discover that California tax rules (for foreclosures and short sales) did not conform to what the federal government has done," said state Sen. Lois Wolk, D-Davis, who sponsored the legislation. "These people have suffered enough. To consider the decline in the value of their loans as income, that's unacceptable."


Expiration Dates
When the foreclosure crisis started, Congress passed the Mortgage Forgiveness Debt Relief Act of 2007 so foreclosed homeowners would not be liable for their canceled debt. It is in force through 2012. California had a similar law, but it expired at the end of 2008, leaving Californians who lost their homes in 2009 potentially liable for big state tax bills.


In the nine-county Bay Area, 27,530 homes were repossessed as foreclosures and 9,522 were sold as short sales in 2009, according to data compiled by ZipRealty.


Tax experts advise people who lost their homes in 2009 to file for an extension in hopes that California will rectify matters.


Several other pending bills would align the state with federal tax law, and Schwarzenegger has indicated that he would sign a bill that focuses only on this issue. "The governor is supportive of a clean tax-conformity bill," said Mike Naple, a spokesman for his office.


People who lost their homes to foreclosure or short sale may still have some tax liability at both federal and state levels, though.


The tax exclusions apply only to money used to purchase, build or fix up a home. Foreclosed-upon homeowners who took money out of their homes for purposes other than rehabbing - to pay off credit cards or buy a car, for instance - must report that forgiven debt as taxable income.


A Homey ATM
"Many people used their house like an ATM machine," said Steve Moskowitz, a San Francisco tax attorney. "If the debt is forgiven, those people find themselves in problems with the IRS unless they qualify for an exception because of bankruptcy or insolvency," that is, their liabilities outweigh their assets.
Moskowitz said he hears from many people in such a situation. "It's a shame," he said. "These people thought, 'Thank God, I'm out of trouble now,' but then they get a 1099 (an income-tax form from the bank showing their discharged debt) with a big number on it."


Vacation Property
Forgiven debt on homes that were not principal residences, such as investment property and vacation homes, is subject to tax liability. However, for many rental properties, the loss in value basically cancels out the phantom income of the canceled debt.


The worst-case scenarios for tax liability are vacation homes and investment property that was never rented out, said Cherry Comstock, a tax practitioner and an enrolled agent with Jet Tax in Antioch .
Experts emphasize that it's crucial for people contemplating foreclosure or short sale to get tax and legal advice well in advance of taking any action.


"At the very least they will have a clear picture of the tax consequences they will be facing," Comstock said. "There are many circumstances when getting advice from a tax pro before the event can mitigate the unpleasant tax consequences.

I have been suggesting to clients inquiring about short sale or foreclosure that they contact a tax professional and real estate attorney.  The possible ramifications of these types of transactions are too important to leave to chance.   The clients who have contacted tax professionals and RE attorneys have thanked me for having them take this step. In all instances, the client felt well informed and confident of how to proceed. 

       

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