San Diego short sale


Tuesday, June 17, 2008

California Taxation - short sales, foreclosures, mortgage debt relief

From the California Franchise Tax Board website...

Foreclosures and the next wave: taxes due on canceled debt
Taxes due on canceled debt

Mortgage defaults and foreclosures are a national concern. Only two states exceed California in rate of foreclosures: Nevada and Colorado. Thousands of Californians are already facing mortgage defaults, or soon will be.

Recent information on national foreclosure rates shows several California cities in the top 15, with Central California counties tending to have higher rates compared to other regions in California 1. The central valley experienced an explosion of homebuilding beginning in 2000, with home prices doubling over a four-year period. For the first half of 2007, California's capital Sacramento had one foreclosure for every 36 households - a 241 percent increase over the same period in 2006. Stockton's rate of one foreclosure for every 27 households in the first half of 2007 puts it at the top of the list: an increase of 256 percent over the same period in 2006 2.

The tax consequences of foreclosure are a second hit for people who have had to walk away from their homes when their adjustable rate mortgages reset to a higher rate. They are often in an upside-down position, owing more on their mortgage than their home is worth. If their lender forecloses on their homes, or accepts an amount less than the loan balance from sale of the home, it may result in taxable gain to the homeowner. The type and treatment of the gain will depend on whether the mortgage is considered non-recourse or recourse debt.

In California, purchase money mortgages, which are mortgages where the borrowed funds are used to purchase the house, are generally treated as non-recourse debt. If the bank forecloses on a non-recourse mortgage, then the homeowner is treated as having sold the home for the amount of the outstanding debt. The difference between the outstanding debt and the homeowner's adjusted basis in the house is considered a gain or loss on the sale of the home. If the home is the taxpayer's principal residence, where they have lived for at least two of the past five years, the gain may be eligible for the gain exclusion on the sale of a principal residence. If the foreclosure results in a loss, the loss may not be taken since it resulted from the sale of a principal residence.

If the mortgage is recourse, such as a non-purchase money mortgage or a refinanced mortgage, any foreclosure may result in a gain on the sale of the house, and/or cancellation of debt income. The difference between the fair market value of the house and the homeowner's adjusted basis will result in a gain or loss on the sale of the home. To the extent the outstanding debt exceeds the fair market value of the house, the amount is treated as cancellation of debt income. Any gain on the portion treated as the sale of a personal residence may be eligible for the exclusion on the sale of a principal residence; however, as discussed above, the loss may not be taken on the sale. The portion that is treated as cancellation of debt income is taxed as ordinary income - subject to ordinary income tax rates. Your clients with canceled or forgiven mortgage debts may receive a Form 1099-C from the lender and will be expected to pay federal and state tax on the canceled amounts, at the ordinary income tax rate.

For example, if the homeowner has a non-recourse mortgage with an outstanding balance of $250,000, and has an adjusted basis of $100,000, the house has a fair market value of $200,000. If the homeowner's lender foreclosed on the mortgage, the homeowner would have taxable gain of $150,000 ($250,000 less $100,000). If the mortgage had been recourse, the homeowner would have gain on the sale of the home of $100,000 ($200,000 less $100,000), and cancellation of debt income of $50,000 ($250,000 less $200,000).

Tax on this seemingly "phantom" type of income is due whether the bank forecloses on the mortgage, or allows a "short sale" (allowing the defaulter to sell the house at below cost, and accepting the proceeds as payment in full). A short sale is preferable to a foreclosure only in the sense that it does less damage to the homeowner's credit rating. The difference between the amount owed to the lender, and the amount received is still considered canceled debt, and taxed at the ordinary income rate. Relief of debt is considered income because the bank gave the buyer cash to purchase the home when it issued the mortgage. This cash was not taxable because it was a loan, and the buyer promised to repay it. When the loan is forgiven or canceled, it becomes income in that year since the buyer will no longer repay it.

Federal legislation to provide relief for the thousands of homeowners caught in the foreclosure squeeze is receiving a lot of attention. Proposed new, bipartisan legislation on Capitol Hill could soften some of the effects on financially stressed homeowners. The Mortgage Cancellation Tax Relief Act of 2007 would amend the tax code to exempt debt forgiveness on principal home mortgages from being treated as income effective on the date of passage. However, if it does pass, it would need to be made retroactive in order to help those homeowners already affected. And, there is no guarantee that California will conform to the potential new federal law immediately.

There are a couple of options for your clients who are caught in this situation:

* Bankruptcy: Debts discharged in bankruptcies are generally not considered debt-cancellation income.
* Insolvency: Tax will not be assessed on the phantom debt-cancellation income if your client can prove insolvency existed when the debt was discharged. Your client must prove that all assets totaled less than all debts.

If you have clients who have exhausted their options and cannot pay the additional tax on the phantom income they "accrued" through debt cancellation, remember to look into our offer-in-compromise and payment arrangement programs.

You may also want to check out the IRS new Web page devoted to foreclosure tax relief, and related FAQs.