Taxation of short sales in California

For some the mortgage debt forgiveness act may apply.
Also, note - you must consider taxation issues with the California Franchise tax board as well as the IRS if you have property in California

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The IRS does recognize four situations in which cancellation of debt will not result in tax liability for the seller. A seller may avoid tax liability:

* When the borrower receives a bankruptcy discharge and the deficiency was included in the bankruptcy
* When the borrower is insolvent at the time of the cancellation of the debt. Insolvency would occur when a borrower’s liabilities exceed assets. Note that seller would have to prove this insolvency to the IRS when filing a tax return.
* When the debt was secured by a nonrecourse loan. Under a nonrecourse loan, the lender does not have the legal right to collect a deficiency judgment from any assets of the debtor not pledged to secure the loan. While most home mortgages are do not fall into this category, purchase money loans on a person’s residence are nonrecourse in some states.
* When the tax liability from the cancellation of debt on an investment property can be offset against other business liabilities and expenses. This exception does not apply to properties occupied as a residence by the mortgagor.

In many short sales, a seller would be able to qualify under the first two of these exemptions, especially since it was almost certainly necessary to show financial hardship in order to convince the lender to agree to a short sale. However, it is the seller’s responsibility to notify the IRS why the amount in the 1099-C should not be counted as ordinary income. Otherwise, the IRS will consider the forgiven debt as income and penalize the seller for unpaid taxes.