I am short selling my home. My loan is for a lot more money than what the short sale is. Do I have to pay taxes on the amount I sell the home for or the amount of my original loan. The difference is quite a lot of money, about $175,000?
Homeowners facing foreclosure or considering a short sale in California are often concerned about two issues: deficiency judgments, and income tax on cancellation of debt. The following discusses these issues in the context of a non-recourse loan.
First of all, there is no deficiency permitted if the loan is a non-recourse loan. California is best known as a non-recourse loan state that makes it hard for lenders to sue.
Secondly, effective January 1, 2011, Senate Bill 931 makes it unlawful for lenders who enter into short sale agreements to require repayment of any amount over the sale price of the property. Senate Bill 931, which adds Section 580e to the California Code of Civil Procedure, provides that a seller's first trust deed lender cannot obtain a deficiency judgment against the seller after a short sale. By providing written consent to a short sale, the first trust deed lender becomes obligated to accept the sales proceeds as full payment and discharge of the remaining amount owed on the loan. SB 931 applies to first trust deeds secured by one-to-four residential units, but does not limit the lender from seeking damages for fraud or waste by the borrower.
Under the federal Mortgage Debt Forgiveness Tax Relief Act of 2007 (applicable till the end of 2012), you will not need to pay any income tax on canceled debt (which is the unpaid loan balance that is forgiven by lender) resulting from a foreclosure, short sale or deed in lieu of foreclosure if you as the borrower satisfy certain conditions for mortgage tax relief (e.g., principal residence, owned for at least 2 years, debt amount of $2 million or less). However, the Mortgage Debt Forgiveness Tax Relief Act of 2007 does not apply if the property is not a "principal residence". IRS Code section 121 defines "principal residence" as: ". . . during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer's principal residence for periods aggregating 2 years or more. "
Forgiveness of a non-recourse loan resulting from a foreclosure or short sale does not result in cancellation of debt income (even if the property is not a principal residence). However, it may result in other tax consequences, for example, if there is reportable gain from the disposition of the home.
For more information on debt forgiveness, 1099-A, and 1099-C, see:
Real Estate Attorney
You should check with your CPA on this. If you do pay tax - and that is a big if, it is on the amount of the debt discharged.
The reason why I said it is a "big if" is that in most cases, you definitely don't have to worry about federal. However, with the state, there's a very complex criteria that the state uses to determine if you are exempt. So speak to your CPA about the state. I've helped many clients in short sale situations. Most told me their CPAs told them they are fine with both state and federal.
If you need more explanation, give me a call.
I would like to add two other potential ways to avoid the cancellation of debt income from being taxable to those listed of the prior attorney. If you do not qualify for complete or partial relief under SB 931 or the Mortgage Forgiveness Debt Relief Act of 2007, you still have code Section 108 of the Internal Revenue Code (which CA follows - the only partially follow the 2007 Act). Under Code Section 108 in you are insolvent at the time of the cancellation of debt you do not have to recognize the income to the extent of your insolvency, and if you are bankrupt you do not have to recognize the income if the debt was included in your discharge.
Any individual seeking legal advice for their own situation should retain their own legal counsel as this response provides information that is general in nature and not specific to any person's unique situation. Circular 230 Disclaimer - Advice given in this response cannot be used to eliminate penalties with the IRS or any other governmental agency.