Can you be held liable for more taxes if you short sell your house?

It’s the political push and pull that we’ve been dealing with for years across America, the threat that hangs over a homeowner’s head: If you sell your house for less than what is owed on it, is the forgiven debt ‘income’ that you can be taxed on? The Feds had this nebulous double-punishment for a homeowner that has already suffered some kind of loss — job loss, death of an income-producing spouse, debilitating illness, divorce — combined with the loss of the family home, and then to put the cherry on the sundae, be taxed for it.  This was addressed with the Mortgage Relief Act of 2013 on the Federal Level, but with the expiration of that Act at the end of this year, the tax liability at the State level conflicts with that at the Federal level. California exempts its residents from taxation in a short sale, but with the expiration of the Act on December 31, 2013, where does that leave Californians who have to short-sell their home, for any reason, when it comes to Federal taxation?

The Feds have finally made a ruling and it’s good news.

No Federal Debt Relief Income Tax on Short Sales

The California Association of REALTORS (C.A.R.)  has been working with California Sen. Barbara Boxer to protect distressed homeowners from debt relief income tax associated with a short sale in California.  As part of this effort, Sen. Boxer requested the Internal Revenue Service (IRS) to provide guidance on whether mortgage debt forgiveness in a lender-approved short sale would be taxable income under federal law, given California’s recent non-recourse laws for short sales, which were hard fought victories by C.A.R.

The IRS has clarified in a letter that California’s troubled homeowners who sell their homes in a short sale are not subject to federal income tax liability on “phantom income” they never received.  The IRS recognizes that the debt written off in a short sale does not constitute recourse debt under California law, and thus does not create so-called “cancellation of debt” income to the underwater home seller for federal income tax purposes.  This clarification rescues tens of thousands of distressed home sellers from personal liability upon expiration of the Mortgage Forgiveness Debt Relief Act of 2007 on Dec. 31, 2013.

C.A.R. is seeking a similar ruling from the California Franchise Tax Board (FTB), which has been awaiting the IRS action; C.A.R. anticipates the FTB will act promptly.  Short sales may raise other tax issues and, as always, consumers should speak with their tax professional regarding the tax consequences of a short sale.

Theresa Grant is a Short Sale and Foreclosure Resource specialist certified by the National Association of Realtors. She can be reached at (909) 336-7933 or via email at Theresa@HomesInLakeArrowhead.com.

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