Finally settling a looming issue for many underwater homeowners, according to new clarifications from the IRS and California’s Franchise Tax Board (FTB), short sales in California are generally not subject to state or federal income tax pertaining to the cancellation of debt. (I.e. if you bought your home for $500,000.00 and “short sell” for $400,000.00 – that $100,000.00 “forgiveness” will not be taxed in California as it once was).

These recent clarifications will provide relief for short sale sellers given that the tax break for a qualified principal residence under the federal Mortgage Forgiveness Debt Relief Act of 2007 will expire at the end of 2013, and similar protection under California law already expired in 2012.

According to the recent FTB clarifications, “a California taxpayer would not have cancellation of indebtedness where the taxpayer was involved in a short sale pursuant to CCP section 580e.” Section 580e of the California Code of Civil Procedure generally protects borrowers from owing a deficiency after a short sale of a residential property with one-to-four units, including both first and junior trust deeds. Exceptions include fraud, waste, cross-collateralized loans, and borrowers that are corporations, LLCs, or limited partnerships.

Of course, numerous complexities in each transaction may be different (including capital gains considerations) and sellers should consult with their own tax and/or legal professionals.

Sources:
California Franchise Tax Board
Internal Revenue Service
California Association of REALTORS®
http://www.car.org/legal/taxfolder/georgerunner/
http://www.car.org/media/pdf/IRS_letter.pdf

-Devin Lucas