Does a Short Sale Have Tax Liability in Calfornia?
A third of all mortgaged homes in California were worth less than their mortgages in early 2010, according to real estate data firm Corelogic. Owners struggle with their limited options every day. The federal and state short sale taxation laws applicable in California are proving to be good reasons for these owners to consider short sales.
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Pre-2007
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Before so many homes in California went under water--that is, declined to a value less than the mortgages secured by them--the taxation laws on mortgage debt were not kind. Any debt you walked away from, including that attributable to mortgages, was considered taxable income, both by the IRS and the state of California. Because California employs tax rates yielding the fifth highest per capita tax revenue in the country, the combined state and federal tax bill on that debt could be significant.
2007-2012: Federal Law
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The Mortgage Forgiveness Debt Relief Act of 2007 exempts mortgage debt arising from foreclosures and short sales from federal taxation. The law applies to personal residences only, with an upper limit of $2 million. It is legislated to expire in 2012.
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2007-2012: State Law
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Mirroring the federal exemption, the California legislature passed its own mortgage forgiveness debt relief legislation that also is in effect from 2009 through 2012. Like the federal bill, the state law only applies to principal residences. If you sold a rental property through a short sale you will be on the hook for both state and federal taxes.
The Underlying Debt
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Even if you have to pay taxes on the unpaid debt, because you are an investor, consider yourself lucky. In 2010 the California legislature passed a mortgage deficiency judgment bill specifically related to short sales. The law, which went into effect Jan. 1, 2011, requires that a lender forgives the debt associated with any first mortgage on a short sale for any one- to four-unit residential building. California's foreclosure rules only prevent lenders from going after borrowers for the balance of mortgage debt when the loan was taken out for the purpose of buying the property--that is, it was the original loan, not a refinanced one. The short sale deficiency law prevents lenders from going after any first-mortgage debt, including refinanced loans.
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References
- Corelogic: New Corelogic Data Shows Decline in Negative Equity
- Indexmundi.com: Tax Collection by State and Tax Type
- IRS: The Mortgage Forgiveness Debt Relief Act and Debt Cancellation
- California Franchise Tax Board: Mortgage Forgiveness Debt Relief Extended
- Around the Capitol: SB 931
- Justia: California Code of Civil Procedure
- Photo Credit tax forms image by Chad McDermott from Fotolia.com
