The California Franchise Tax Board (“FTB”) issued a letter summarizing their position regarding the tax impact of short sales. The FTB followed suit with the IRS’ position, meaning there will not be any California state tax impact for a majority of taxpayers in this position (See my previous blog post regarding the IRS’s position). The FTB stated:
“For federal and California income tax purposes, if a loan is nonrecourse, meaning that the lender has no recourse against the borrower for any deficiency in satisfying the full amount of the indebtedness other than taking possession of the underlying property [the] borrower will be treated as having sold the property for the amount of the outstanding debt or the fair market value of the property, whichever is greater. Therefore, the borrower may have gain to the extent the outstanding debt or fair market value exceeds the borrower’s basis in the property.
If a loan is recourse, meaning that the borrower may also be personally liable for the obligation and the borrower is relieved of all or a portion of the obligation, the borrower may have a taxable income in two respects. The borrower may have a gain on the short sale to the extent the fair market value of the property exceeds the borrower’s basis in the property sold. The borrower may also have cancellation of indebtedness income equal to the forgiven amount of the loan.”
The FTB’s position is good news as the federal Mortgage Forgiveness Debt Relief Act of 2007 will expire at the end of this year and a similar protection offered by California expired in 2012. Although gains may be taxable, 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’ and the FTB’s guidance should alleviate any potential Federal tax liability for California short sellers.
As always, you should seek professional tax advice regarding the tax consequences for your particular short sale situation.