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California and feds diverge on mortgage forgiveness tax exemption

For decades, the structure of the federal income tax system has exerted considerable sway over state income tax systems. To be sure, there are several states that don't impose personal income taxes. States that do impose such taxes, however, have generally followed the federal lead regarding how tax deductions, exemptions and credits are handled.

More recently, though, there has been a growing gap between the federal system and how many state income-tax systems handle such calculations.

In this post, we will look at a recent example of this in California. It concerns the availability of a tax exemption for so-called "phantom income" from mortgage debt relief that occurred through foreclosure or a short sale.

In a technical sense, forgiven mortgage debt is considered income for former homeowners. But it is "phantom income" in the sense that those homeowners never actually pocket a penny of that income.

At the federal level, Congress determined that asking homeowners who had lost their houses to pay income tax on the amount of mortgage debt that they no longer owed would be adding insult to injury. After all, the very reason most of these people lost their homes is that they were hurting financially.

The California Legislature initially followed the federal lead in creating a tax exemption for this purpose. But California only did this for one year, on a temporary basis.

When the temporary exemption expired at the end of last year, it was necessary for the California Legislature to revisit the mortgage debt forgiveness issue. The result, unfortunately, was a failure to extend the tax exemption.

The Senate did pass a bill called SB 30 that would have continued the exemption. But the bill contained a contingency clause that prevented it from taking effect unless another bill was also passed. The other bill would have added fees to real-estate transactions and applied the fee revenue to low-income housing projects.

Ultimately, in the political maneuvering in Sacramento, neither bill passed. As a result, the tax exemption that benefited former homeowners after a foreclosure or short sale was not continued. And California's tax code moved one step farther out of alignment with its federal counterpart.

Source: The Sacramento Bee, "California's tax system is out of whack," Dan Walters, Nov. 11, 2013

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