California Homeowners Short Sale Tax Relief

Distressed California homeowners who sell their homes via a short sale to avoid foreclosure will not be subjected to state income tax liability on debt forgiveness after the federal law prohibiting such penalties expires at the end of this year.

The Internal Revenue Service recognized in November that the debt written off in a short sale does not constitute recourse debt under California law. Therefore, this does not create so-called cancellation of debt income to the underwater home seller for federal income tax purposes.

After the IRS’s clarification, the California Association of Realtors sought a similar ruling from the California Franchise Tax Board, which was made earlier this month.

“We are pleased with the recent clarifications issued by the IRS and the California Franchise Tax Board, which protect distressed homeowners from debt relief income tax associated with a short sale in California,” said Kevin Brown, president of the California Association of Realtors. “Distressed California homeowners can now avoid foreclosure or bankruptcy and can opt for a short sale instead, without incurring federal and state tax liability, even after the Mortgage Forgiveness Debt Relief Act of 2007 expires at the end of this year.”

Despite a housing market recovery happening throughout the Golden State this year, CAR is projecting as many as 55,000 short sales for 2014 with an average debt forgiven of $60,000 per short sale, an amount that could have been taxable without the IRS’s ruling.

Overall, the cumulative tax hit for Californians would have surpassed $50 million if the ruling did not occur, the Franchise Tax Board said.

Under current state law, when a lender forgives mortgage debt in a short sale, the seller must pay state income tax on the amount of forgiven debt. The previous California exemption lapsed at the end of 2012, so forgiven mortgage debt on short sales that took place this year is considered taxable state income.

Realtors tried to get a state tax break for borrowers who short sale their property to conform to the debt relief law that was extended at the federal level which is set to expire on Dec. 31, but this stalled in the legislature. So if a California homeowner theoretically sold a home for $400,000 but owed $500,000, they would be forced to pay taxes on $100,000 of forgiven debt.

However, the latest IRS and FTB ruling is positive news for thousands of homeowners who could have been facing foreclosure or bankruptcy rather than seeking short selling to avoid a large tax bill.

“California homeowners have struggled through years of economic hardships during the Great Recession,” says Sen. Barbara Boxer, D-Calif. “I am relieved that these families will not face a burdensome tax penalty just as they are trying to rebuild their lives with a short sale.”