IRS and CA Waive Debt Forgiveness Tax
News has been flying around the Internet based upon a recent IRS letter released by Senator Barbara Boxer and the California Assn. of Realtors stating that they would not be taxing debt forgiveness on short sales. Today, we’ll look at that news and the rationale behind it.
Debt Forgiveness occurs whenever a property is transferred and the lenders are not paid in full... such as in a Short Sale or a Foreclosure. Under our nation’s Federal Tax Code, the IRS considers the amount unpaid as being taxable income (technically called “Cancellation of Debt Income”). In 2007, Congress passed the 2007 Debt Forgiveness Relief Act (the “Act”) which gave an exemption from this tax under certain conditions… primarily if the property was the debtor’s personal residence. California followed with a similar law. Throughout 2013, one of the most important topics on the minds of upside-down property owners was whether Congress would extend the Act beyond its 12/31/13 expiration date. California posed an even greater question since, due to political game playing, CA didn’t even offer the tax relief for 2013!
Significantly, unrelated to the tax issue, on July 15, 2011 California passed a new law commonly called “SB458” which became CA Code of Civil Procedure Sec. 580(e). This law solely dealt with anti-deficiency liability after short sales and simply said that no lender could have recourse against a borrower after a short sale, ie: it became “non-recourse”. This law will continue operating after 12/31/13. Although 580(e) had nothing to do with debt forgiveness taxes or the Act, events in 2013 connected the two by raising the question of whether another IRS exemption for “non-recourse” debt might apply.
Realizing that Congress was not moving forward on extending the Act and that California had blocked the tax relief for 2013, last August California Senator Barbara Boxer sent a letter to the IRS asking whether there would be taxable income on a short sale under CA CCP Sec. 580(e). On September 19th, the IRS sent her a response that stated: “We believe that a homeowner’s obligation under the anti-deficiency provision of section 580e of the CCP would be non-recourse obligation to the extent that, for federal income tax purposes, the homeowner will not have cancellation of indebtedness income. Instead, the homeowner must include the full amount of the non-recourse indebtedness in amount realized”.
This was and is great news and appears to be consistent with other IRS publications, particularly the IRS’s own guide to Cancellation of Debt Income, IRS Publication 4681. Publ. 4681 which identifies that if the loan was non-recourse, then the entire amount of the debt is treated as the amount realized and may or may not result in capital gain or loss. The IRS reply to Sen. Boxer appears to clarify that, at least as to CA short sales, there should not be debt forgiveness tax. Further, since both CA 580(e) and the IRS Code will continue in effect after 12/31/13, Californians attempting short sales in 2014 should be able to breathe a sigh of relief knowing that any amount unpaid should be free of either a Judgment risk or a tax risk.
Of even greater benefit to Californians, in December our State Board of Equalization (the State’s IRS) ruled that since they follow Federal law on this, that short sales will similarly be exempt from CA debt forgiveness tax… even ones that closed in 2013!
While we might hope that this ruling will also be extended to foreclosures which also become non-recourse under CA CCP Sec. 580(d), we are all thankful for what we’ve been given and hope that the rising real estate market will lift all upside down owners to at least a break-even position.
If you are facing a possible tax issue because of a 2013 short sale or anticipate one in 2014, be sure to consult your own accountant in advance so that you can know the full impacts of cancellation of debt income on your situation. Remember, there are at least five separate and distinct exemptions to avoid this taxation. At least one may apply to you.
BPE Law has been assisting our clients with their real estate, business, estate planning, and other legal needs ever since we started doing business nearly 20 years ago. We’re active in the communities in which we live and in protecting and expanding our clients’ opportunities for business and real estate ownership … and providing assistance when they’re challenged. If you have questions concerning your estate plans, real estate, business, or any other legal matter, give us a call at (916) 966-2260 or e-mail me at firstname.lastname@example.org. Our flat fee consult for new clients may get you the answers you need for the questions you have.
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.