While the number of short sales has declined dramatically, there are still a number out there and those who are doing short sales remain concerned about the tax implications. Will they be subject to cancellation of debt (COD) income? Unfortunately for California taxpayers the answers are not completely clear and there may be different results under federal and California law.
Recourse Debt: A short sale involving recourse debt (generally non-homeowner, investor debt), where the lender agrees to reduce some or all of the outstanding debt, may give rise to income. The amount of the debt that the lender agrees to write off is treated as cancellation of debt (COD) income.
This COD income, which is treated as "ordinary income" under certain circumstances, may be subject to taxation. However, a claim of insolvency may provide relief from COD income. Additionally, there may be capital gains realized.
Non-recourse Debt: COD Income, Capital Gains and California Code of Civil Procedure Sections 580b and 580e
Federal Law – The Protecting Americans From Tax Hikes Act of 2015 extended the Mortgage Debt Relief Act for debts discharged before January 1, 2017 or if the discharge was pursuant to a binding written agreement entered into before January 1, 2017. Under the Mortgage Debt Relief Act (codified in IRC Section 108), the discharge of acquisition indebtedness (up to $2,000,000 of debt used to acquire or substantially improve a qualified principal residence (IRC Section 108(h)) is treated as capital gains and not as COD income. As before, single or joint tax filers selling a principal residence can use the appropriate $250,000 or $500,000 capital gains exclusion.
California Law - California law has generally conformed to federal law. But with Governor Brown’s veto of conforming legislation in October 2015, it is unclear how the Franchise Tax Board will treat forgiven debt, even if the debt is non-recourse. Will it be treated as taxable COD income or will it be treated as capital gains?
Despite the Governor’s veto, California Code of Civil Procedure sections 580b and 580e may yet establish the non-recourse character of residential purchase money loans even in a short sale, and thus exempt such debt from COD income. Additionally, the FTB had earlier written a letter indicating that a homeowner who enters into a short sale would be treated as having been relieved of a non-recourse obligation.
In response to the prior expiration of the Mortgage Debt Relief Act, Senator Boxer requested that the IRS clarify its position on short sale debt relief and the implications of CCP sections 580b and 580e. The request produced a series of three letters from the IRS and one letter from the FTB. The IRS letters used the term "homeowner" and focused on the nature of the debt at its inception. Although this narrowed the possible expansive interpretation of "non-recourse" debt under the CCP, it did indicate that forgiveness of original debt incurred to purchase a home would not result in COD income but instead would result in capital gains and be subject to exclusion from taxes.The FTB had appeared to agree but a later statement from them leaves some question because they say that a discharge of "qualified principal residence indebtedness" for federal purposes “may be required to be included in the taxpayer’s California income."
A desirable and perhaps likely outcome is that the FTB will not treat non-recourse forgiven debt as taxable income but as capital gains.
Nonetheless, as always, REALTORS® must advise their clients that they cannot give tax advice and that the client should seek tax advice from a qualified tax professional.
For a fuller discussion of the recent extension of the Mortgage Debt Relief Act, and copies of the IRS and FTB letters, see the Legal Q&A Taxation of Foreclosures and Short Sales (revised January 26, 2016).
- Sunil Sethi
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