California State Tax After Short Sale?

 

Hang your hat on if you owe on a short sale

Former President George W. Bush's "Mortgage Forgiveness Debt Relief Act and Debt Cancellation" of 2007, changed Federal laws. Before this date, all debt forgiven in a short sale was taxed as ordinary income.

To translate:
 the difference between what you owed a lender and what the house sold for was treated as income for the tax year.  Before 2007 you would receive a 1099 for the gain of forgiveness of debt. The Mortgage Forgiveness Debt Relief Act ended the claiming this as additional income on your Federal income tax return. MFDRA allows taxpayers to exclude debt forgiven from the short sale of a principal residence from 2007 extended through 2013 year end.

Cancelled mortgage debt through a short sale of up to two million dollars for couples filing jointly is excluded on your federal IRS returns. Or one million dollars if you are married filing a separate tax return from your spouse. This rule was extended until the end of 2013 and has not been extended into 2014, yet.

States are dealing with this separately. California has no law in place that allows you to file this April 2014 with an exclusion. If you live and work in California and sold your primary residence short last year how will your accountant show the income on your State income tax filing due in just twelve days?
 

There are some ins and outs to this law.  Acquisition debt, or purchase money loans are treated differently than home equity debt or cash out refinances. Acquisition debt and home equity debt are not the same under the law. It is important to know what you can file, and hopefully you received advice from your Realtor and tax advisor if you closed a short sale in 2013. Acquisition debt is debt or a mortgage loan used to buy, build, or improve a principal residence. Home equity debt is any loan whose proceeds were not used to buy, build, or improve the residence. Note this is  ONLY for a primary residence.

Acquisition debt can be excluded from tax under the Mortgage Forgiveness Debt Relief Act. Home equity debt cannot be excluded under this new law. Instead, home equity debt may qualify under the insolvency or bankruptcy exclusions. In order to qualify under this exclusion assume you will have to show you have close to zero assets.

For divorced couples, the rules on canceled mortgage debt are uniform but applied differently. Using that same example, if $350,000 of the value of the debt is canceled, both homeowners will get the 1099-C. How will you decide how to will split the responsibility? Hopefully your divorce attorney is aware of this pickle. The easiest, of course, is a simple 50-50 cut, which means each will report $175,000 in canceled debt.

If you've used a home-equity line of credit for home improvements and the like, that too is spared of tax consideration if canceled. Be prepared to show documentation supporting those claims. You will need to save any construction receipts, Home Depot bills, breakdowns of major landscaping or a pool, plus cancelled checks. Save these for seven years with your tax returns, in case you are audited. Assume is you are paying Alternative Minimum tax, you will be audited for this exclusion (they will be looking for deeper pockets).

Home-equity lines of credit used to pay off credit cards or buy a new car, boat, toys... are taxable if canceled via a short sale or foreclosure.

This is not tax advice, it is a call to Jerry Brown...