California Tax Payers Who Commit

¶ … California tax payers who commit a short sale is to report any debt forgiven as an extra source of income. This could increase the tax liability of the person resulting in inceased payments to their income tax.

If a cancellation of debt occurs, the total amount of the debt forgiven is reported by the lender to the IRS on a form 1099-C and usually translates to taxable income. There are however certain circumstances that can keep a person from having to pay any taxes on the cancelled debt such as bankruptcy, Qualified principal residence indebtedness, and insolvency among other situations. Since Danny has neither bankruptcy or insolvency, most likely he will not be exempt.

Short sales have their advantages and disadvantages. Danny made home improvements to a home that was supposed to be worth $1,500,000. He got an offer of only $600,000. Instead of taking the loss completely he opted for a short sale that has the ability to grant him complete debt forgiveness of the amount left over after the $600,000 payment. Danny managed to sell $600,000 worth of home. The potential $900,000 left over can be completely forgiven with the only payment being having to pay tax on the forgiven leftover amount.

If homeowners somehow managed to have their homes sold under a short sale before there is a tax lien put on the home from any tax collector, then there can be no tax lien established on the property to secure the debt. This signifies a substantial advantage for the homeowner due to the new options made available to the homeowner and the limited amount now owed by the homeowner. If it were not for the short sale, Danny would have been forced to have the inability to sell his property under the restrictions of the taxlien.

The disadvantage of a short sale is that it is often a long and tedious process often requiring a lawyer. If one is able to manage to get the short sale done, any amount forgiven through the short sale must then be reported by the homeowner in their taxes. This can lead to increased tax liability and having to pay more for their income tax.

Cancellation of debt is almost the same thing as a short sale with the consequences slightly being different then a short sale. "If the loan is a recourse loan, then depending on the facts, you may have COD income, and potentially a reportable gain, in which case you would want to determine if one of the provisions in IRC section 108 would apply, allowing the COD income from the discharge of indebtedness to be excluded." (Foreclosure and Short Sales 2012) The consequences being that the cancelled debt may or may not be qualified for taxation depending on any qualifying exemptions. Since Danny is not bankrupt or insolvent, it is most likely he would have to pay tax on the cancellation of debt income.

Some of the exemptions that quality for a person to not have to pay tax on cancellation of debt income are the following:

Qualified principal residence indebtedness: This exception is thanks due in part to the creation of the Mortgage Debt Relief Act of 2007 and applies to most homeowners, in this case Danny.

Bankruptcy: Any debts dismissed through bankruptcy do not qualify as taxable income..

Insolvency: Is almost like bankruptcy in the sense that the total debts owed are more than the fair market value of a person's total assets.

Non-recourse loans: A non-recourse loan is a loan that the lender's only fix in case of certain default which is to reposses any property being used for collateral or finance. Cancellation of debt in this instance may not be taxed in this manner but might be taxed another way.

Certain farm debts: This exemptions only applies to debt incurred directly from an operation of a farm. If more than half your income from the past three years came from farming, and the loan was owed to a person or agency regularly engaged in lending, your cancelled debt is generally not considered taxable income.

Analysis

Since 2007 and 2008, California conformed, with modifications to IRC section 108 (a)(1) (E) that allows a limited amount of COD income resulting from the foreclosure or short sale of a qualified principal residence to be excluded. This exclusion does not currently apply for any foreclosure or short sale that occurs on or after January 1, 2009. Danny made his short sale in 2012. "The Mortgage Forgiveness Debt Relief Act of 2007 was enacted on December 20, 2007 (see News Release IR-2008-17). Generally, the Act allows exclusion of income realized as a result of modification of the terms of the mortgage, or foreclosure on your principal residence. " (The Mortgage Forgiveness Debt Relief Act and Debt Cancellation 2012) This act passed would have helped Danny if the sale was made prior to 2009. Current findings point to the need for Danny to pay taxes on the short sale and any cancellation of debt assumed by the process.

There is a new law in California Senate Bill 458, signed into law on July 15, 2010 and effective immediately as an urgency statue, corrects major defects in Code of Civil Procedure Section 580(e). This law states that when any lender agrees to a short sale, it cannot go after the borrower for any shortfall or deficiency between the sale proceeds and the loan amount. Although this has nothing to do with the taxes incurred through the short sale or COD, it does however keep Danny from being hasseled over the left over deficiency.