Whenever a borrower fails to pay back a loan in full and the lender chooses not to sue the borrower for the deficiency, the result is that debt has been forgiven. The IRS considers such forgiven debt to be income received by the borrower, technically called “Cancellation of Debt Income”, and the borrower must pay income tax on it … unless the borrower has an exemption. The same happens in California triggering a state tax liability.

For people who lost their homes in foreclosure, or participated in a short sale, or who even got a loan modification this came as a shocking and financially devastating surprise. For example, if a person owing $400,000 in debt on their home, short sells the home for $300,000, they would have to report $100,000 more income on their Federal and State tax returns. This could result in a tax liability of $40,000 or more!

In 2007 as the real estate market was collapsing, the Federal government passed the Mortgage Forgiveness Debt Relief Act which provided an exemption for people who became subject to this tax. Although it generally only applied to personal residences, the Act provided relief to millions. Most states, including California passed matching laws conforming to the Federal Act. Although the original Act was scheduled to run only until 2009, as the Recession deepened Congress repeatedly extended the Act and California conformed. Until 2014 that is.

In 2014, the Federal government failed to pass an extension of the Act until December 26, 2014 and that only applied to 2014. California failed to pass any relief in 2014 although there was conforming legislation, Assembly Bill 99, that would achieve this retroactively. AB 99 was recently passed by the Legislature and sent to Governor Brown for signing. But last Monday, October 12th, the Governor stunned everyone by vetoing the Bill because he was concerned with the tax impacts on the State. As a result, for Debt Forgiveness that occurred in 2014, the exemption exists on the Federal level, but not in California.

What about 2015 and beyond? At present there are two Bills moving in Congress which if passed will extend the Federal exemption to include both 2015 and 2016. If these do pass, President Obama has indicated that he will sign the extension. But, given what has now occurred in California, it is unclear whether that will negatively affect votes at the Federal level. Plus, of course, we’re coming up on a Presidential election year in which political infighting could further derail legislation.

Regardless of what happens with the Mortgage Forgiveness Debt Relief Act, it is important to understand that there are at least four other exemptions to the tax which may apply:

1. Purchase Money Debt – a loan which is obtained to enable a buyer to acquire a 1-4 unit residence that they occupy, is generally both non-recourse and debt forgiveness is not taxable;

2. Capital Loss on Investment Property – if the value of an investment property drops from its acquisition price, the investor may be able to use this capital loss as an offset against debt forgiveness and thus eliminate some or all of the tax liability;

3. Insolvency – if the amount that a borrower owes to creditors is greater than the amount of assets the borrower owns, the borrower may be determined to be insolvent and could receive an exemption against debt forgiveness tax up to the amount of their insolvency; and

4. Bankruptcy – if the borrower can file for Bankruptcy protection before any debt forgiveness occurs, the Bankruptcy may discharge their personal liability for the deficiency and exempt them from the tax.

The foregoing is obviously a brief explanation of a very involved topic. If you or someone you know if facing debt forgiveness liability for a transaction which has already occurred or is concerned about the tax risks on a future transaction, it is critical that you get competent advice from your tax professional and legal advisors before doing anything that could trigger a tax or other liability.

The attorneys at BPE Law Group have assisted over 6,000 property owners and their agents to understand the issues arising from upside down properties and to develop and implement strategies to minimize and possibly avoid the negative impacts of judgment risk, tax liability, credit damage, and job loss risks. If you need assistance with this, please call our main office at 916-966-2260 to schedule a low-cost consultation appointment either in our Gold River or Sun City Lincoln office.

The information presented in this Article is not to be taken as legal advice. Every person’s situation is different. If you are facing a legal issue of any kind, get competent legal advice in your State immediately so that you can determine your best options.