Homeowners Facing Short Sales in California Can Breath a Sigh of Relief

If a lender decides to relieve a borrower from repaying a debt, then regular tax regulations consider the forfeited debt as a taxable income. The former debtors are required to pay income tax on the forgiven debts. The rule is known as “cancellation of indebtedness.”

The rule could complicate the financial circumstances of many homeowners who were already in difficult situations following the foreclosure crisis that started in 2007. Congress introduced the Mortgage Forgiveness Debt Relief Act of 2007 to avoid such a situation. Under the Act, homeowners are exempted from paying tax on forgiven debt that doesn’t exceed $2 million in short sales on their principal residences. The Act also applies if the debts are forgiven in foreclosures.

The law was initially meant to remain effective until the end of 2009. However, the Congress gave it four more years, meaning that it is expected to expire at the end of 2013. Although there is the possibility of extending the law once more, the Congress does not seem to be in a hurry to do so. There are high chances that the original “cancellation of indebtedness” rule may become effective once more from January 1, 2014. 

In the event that congress doesn’t extend the law, homeowners whose houses are underwater are likely to experience different consequences depending on their states. A number of states have enforced anti-deficiency legislation meant to protect homeowners from lenders who would otherwise hold them personally liable and target their assets in case proceeds from foreclosures or short sales do not cover the amounts of their respective home loans. 

California, which is among the states with the anti-deficiency law, added a provision to the legislation specifically aimed at short sales. The end of the Mortgage Forgiveness Debt Relief Act is unlikely to have any weight for homeowners in California, thanks to the Calif. Code of Civil Procedure 580(f).

According to the IRS homeowners would not have to pay taxes on forgiven debt if they could not be personally held liable for what remained on their loan balances after the sale of their homes.

Had this section not been clarified, forgiven debts in the state, which average $60,000 per short sale, could have been taxable. California is projected to have 55,000 short sales in 2014.