Many people in California continue to short sell their homes. A short sale is when the home is sold for less than the outstanding loan balance. In California, borrowers are generally protected from owing the deficiency resulting from a short sale. However, the debt that is forgiven is taxable at both the state and federal level. The Mortgage Forgiveness Debt Relief Act of 2007 provided a tax exemption for short sellers so they did not have to add this debt forgiveness to their taxable income. This act is set to expire on December 31, 2013.
The California Association of Realtors (“CAR”) along with Senator Barbara Boxer have been working with the IRS and the California Franchise Tax Board to receive guidance on the tax impact for California short sales. The IRS states the following: stated,
On the other hand, if a property owner cannot be held personally liable for the difference between the loan balance and the sales price, we would consider the obligation a nonrecourse obligation. In this situation, the owner would not treat the cancelled debt as income. Instead, the owner must report the entire amount of the nonrecourse debt as an amount realized on the sale of the property. If the owner realizes a gain on the sale of the property, the owner generally must include the gain in gross income (Section 61(a)(3) of the Code). However, if the property was the owner’s principal residence, the owner may qualify to exclude all or part of the gain from income (Section 121 of the Code).
For California short sales, the IRS does not consider the debt forgiven as an amount that is subject to the Mortgage Forgiveness Debt Relief Act as the obligation is nonrecourse. However, the debt forgiven reduces the basis the borrower has on the home. This could result in a potential gain to the homeowner and any resulting gain would be subject to capital gains tax. Some good news is that there is a $500,000 capital gains exclusion on principal residences for married filing jointly taxpayers and a $250,000 exclusion for single taxpayers. For the majority of taxpayers, the IRS’ guidance should alleviate any potential Federal tax liability for California short sellers.
The CAR is working with the California Franchise Tax Board to receive the same guidance, and may alleviate any tax burden for short sellers at the state level as well.
As always, you should seek professional tax advice regarding the tax consequences for your particular short sale situation.