No Tax Penalty on California Short Sales
There has been lots and lots of chatter on the news lately and our phones has been ringing off the hook with Realtors® asking whether the Mortgage Debt Relief Act of 2007 has been extended. We’re gratified that you think of us first as the “all-knowing” when it comes to short sales. But… President Obama and other folks in politics actually don’t call us personally to notify us when important governmental changes home about.
Nevertheless, perhaps you’ve already heard that California homeowners will not face tax penalties when selling their homes as short sales, even though the Mortgage Debt Relief Act of 2007 is scheduled to come to an end on January 1, 2014.
What Is the Mortgage Debt Relief Act?
Initiated by President Bush, the Mortgage Debt Relief Act of 2007 is a tax break that saves certain struggling homeowners from paying taxes to the IRS for the amount of debt forgiven in a short sale, a foreclosure, or a deed-in-lieu of foreclosure. Even though the amount of debt forgiven is reported on the 1099-C, and sent to all borrowers, there are certain aspects of this tax act that preclude the short sale seller from the paying taxes on this forgiven debt. Prior to the enactment of the Mortgage Debt Relief Act of 2007, if the short sale lender forgave $50,000 in debt, borrowers were responsible for paying the income tax (on the $50k) at their current tax rate.
Recent Changes in California
California short sale sellers have been awaiting news as to whether or not the state tax board would follow the federal tax guidelines with respect to debt forgiveness. In fact, when the tax Act was extended, Californians were told that any forthcoming decision at the state level might be retroactive. As of just a few weeks ago, any Californians who participated in a short sale or deed-in-lieu of foreclosure in 2013 still did not know about their own state tax liability. Then, all of a sudden, things changed
As a result of a letter from Senator Barbara Boxer to the IRS, Californians now have clear guidance on the tax laws with respect to short sales. In November, Senator Boxer received a response from this IRS clarifying that California families who have lost their homes in a short sale will not be subjected to a tax penalty for debt forgiven after the federal law prohibiting such penalties expires at the end of this year, and the Franchise Tax Board has agreed with those clarifications.
Enacted in July of 2011, California has an anti-deficiency law that protects homeowners from lenders attempting to collect additional assets in the case of a closed short sale transaction. But until Senator Boxer wrote her letter, the IRS had not clarified how this might play out in California. Like many Californians, Senator Boxer noted that with the end of the Mortgage Debt Relief Act of 2007 just around the corner, “…distressed borrowers may face the unfortunate incentive to go to foreclosure rather than seek a short sale in order to avoid a large tax bill.”
The IRS reply clarified that California families will not face burdensome tax penalties as a result of participating in a short sale—specifically because of the state anti-deficiency statutes. After the IRS clarification, the Franchise Tax Board (on December 6, 2013) made a public statement that they will align their guidelines with those of the IRS.
According to the California Association of Realtors®, there are approximately 55,000 anticipated short sales in 2014 in the state of California, so the letter from the IRS and the Franchise Tax Board statement are good news for those distressed borrowers still on the fence about selling as a short sale.
In a recent Forbes article, Peter Reilly points out that all Californians might not want to do jump for joy just yet. Reilly states, “there are situations where this rule might work against the taxpayer, particularly those who borrowed against property after it appreciated.” He goes on to outline a few of those situations and points out that some of the various exceptions to recognizing debt discharge (including insolvency) will no longer be available remedies.
So, What About Alaska, Hawaii, and the Rest?
Since the argument put forth in the IRS letter specifically relates to California’s anti-deficiency law, it stands to reason that if you live in another state that has an anti-deficiency law, the same logic might apply. But, please don’t take my word for it, and do your due diligence. Why not contact your local congressman and have him or her make an inquiry on your behalf?