Tax Relief for California homeowners facing Short Sales

There could be bad news in 2014 for homeowners who might be involved in a short sale! The Mortgage Forgiveness Debt Relief Act of 2007 enacted by Congress is due to expire at the end of 2013 and there appears to be little urgency in Congress to extend the law. That means starting on Jan. 1, 2014, there is a good chance that the old rules on forgiveness of home loan debt will come back into force.

Fortunately for California homeowners, our state has enacted anti-deficiency legislation that prevents lenders from holding a homeowner personally liable and going after his or her personal or other assets if the proceeds from a foreclosure or short sale are not enough to cover the amount of the home loan.
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Additionally, California beefed up its anti-deficiency rules in 2011 by adding a provision specifically applicable to short sales. (Calif. Code of Civil Procedure 580(f).) What does this have to do with the soon-to-come demise of the Mortgage Forgiveness Debt Relief Act of 2007? It could make it meaningless for most California homeowners.

The IRS concluded that because of Section 580e, a California homeowner who goes through a short sale will not have cancellation of indebtedness income – i.e. the income is not taxable.

This is good news for California homeowners. The California Association of Realtors has projected that even under the recovering housing market, there may be as many as 55,000 short sales in California in 2014. The debt forgiven — $60,000 per short sale, on average — could have been taxable without this clarification.

Background Information:

Under regular tax rules, when a lender forgives a debt the amount of the debt is taxable income to the borrower. A homeowner who has $100,000 in mortgage debt forgiven through a short sale, for example, would have to pay income tax on the $100,000.
This “cancellation of indebtedness” rule could have caused enormous financial hardship to the millions of homeowners whose homes were “underwater” during the home foreclosure crisis that began in 2007.

To prevent this, Congress enacted the Mortgage Forgiveness Debt Relief Act of 2007. This law allowed homeowners to exclude from their taxable income up to $2 million of debt forgiven on their principal residence by a lender in a short sale, mortgage restructuring, or forgiven in a foreclosure.

This law was never intended to be permanent. It was originally scheduled to expire at the end of 2009. However, it was extended for an additional four years. It will now expire at the end of 2013.
For details on state anti-deficiency laws, see the National Consumer Law Center Foreclosure Report.

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