After a foreclosure or a short sale, the former homeowner is not taxed on the forgiven debt under federal and state laws that will expire at the end of this year. When a homeowner can no longer afford to make their mortgage payments two things can happen. The homeowner can negotiate a short sale with their lender in which the lender agrees to let the borrower sell the house for less than the outstanding amount of the mortgage and turn the proceeds from the sale over to the lender as payment in full. Or, the homeowner fails to make the regular mortgage payments and the lender forecloses on the home which results in the lender selling the home to satisfy all or a portion of the outstanding mortgage loan balance.
In both cases, the lender likely ends up receiving less than the full amount of the outstanding balance. If so, the amount the borrower is no longer responsible for paying to the lender is considered “cancellation of debt” (COD) income and, thus, income to the borrower that – prior to the adoption of the federal and state protections – was subject to income tax. However, if any portion of the debt obligation is eliminated – like in a short sale or foreclosure – that portion is considered income and, absent legislation exempting it, subject to taxation.
(Aside from debt forgiveness legislation, there are three instances in which income tax does not have to be paid on COD income. Two are bankruptcy and insolvency. The third is if the mortgage is “non-recourse” debt. There is no personal liability for a purchase money mortgage for a personal residence or financing carried back by the seller. The borrower can simply walk away from the debt and the lender has no recourse for recovering the amount of the outstanding mortgage other than foreclosing and selling the residence. However, if the home was refinanced, any amount financed is “recourse” debt and the lender can pursue the former homeowner for the outstanding balance which previously was subject to income tax. The same is also true of second mortgages and home equity lines of credit.)
The federal Mortgage Debt Relief Act of 2007 applies to debt forgiven through the 2012 calendar year. Senate Bill 401 (Chapter 14, Statutes of 2010) is California’s conforming legislation and applies to discharges of indebtedness occurring before January 1, 2013. The rationale for these measures is that it is unfair to a taxpayer who has just lost their home to also be taxed on “income” which they never actually received (which is sometimes called “phantom income”). Both the federal and state debt forgiveness protections will expire at the end of next year. It is unlikely that the California Legislature would extend the debt forgiveness protections independent of the federal government. If California is going to extend these protections, it will in all likelihood only do so in conformity with federal legislation.
Note: We are not attorneys or tax experts. If you need advice, consult with an appropriate tax or legal advisor. We can refer you to some good folks we’ve worked with if you need options.