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Short sales and debt cancellation income in California: an update

This is a follow up to a story we took note of last month about the availability of a tax exemption for the nominal income taxpayers technically receive from mortgage debt relief following a short sale or foreclosure.

As we explained in our November 13 post, California did not follow the federal lead in creating a tax exemption for that income. The California Legislature passed only a temporary exemption, for one year. Efforts to extend the exemption failed.

It now appears, however, that California revenue officials may be inclined to continue the exemption after all, at least with regard to short sales. In this post, we will discuss that issue.

To be sure, the California Franchise Tax Board has not issued a formal revenue ruling on the taxation of mortgage forgiveness income after the loss of a home. But according to media accounts last week, there are a couple of recent developments regarding the tax obligations of homeowners after short sales.

First, Senator Barbara Boxer raised the issue with the IRS. She received an answer saying that federal tax on debt cancellation income would not be due after a short sale if the debt was type of debt called “recourse” debt.

The IRS issued this letter in full awareness of the fact that the federal Mortgage Forgiveness Debt Relief Act of 2007 expires at the end of this year and has not yet been renewed.

Of course, regardless of what the federal action is, there remains the question of California tax. There are new developments there as well.

A member of the California Board of Equalization named George Runner asked the Franchise Tax Board to articulate its opinion on the tax obligations of homeowners following short sales.

In response, the Franchise Tax Board’s chief counsel said that, concerning debt cancellation income and short sales, California would not be requiring tax to be paid on this income after all. In other words, when it comes to short sales, California would continue to follow the federal lead.

The issue is a fairly technical one, involving the distinction between “recourse” and “nonrecourse” debt. The upshot of the recent developments, however, is that California will apparently not be moving out of alignment with the federal tax code on the taxation of debt cancellation income after a short sale.

Source: SF Gate, "Short sales of homes unlikely to raise taxes," Kathleen Pender, Dec. 7, 2013

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