Short sales of homes unlikely to raise taxes

Californians who sell their primary home in a short sale won't have to pay income tax on any unpaid debt, even if federal and state laws that temporarily waived the tax are not extended, according to recent letters from the Internal Revenue Service and Franchise Tax Board.

The information letters, sent to elected officials in California, do not carry the same weight as a revenue ruling or formal guidance, says Dave Fogel, a certified public accountant in Roseville (Placer County). He believes the IRS and tax board came to the wrong conclusion and says borrowers "should wait until the dust settles" before making any decisions based on the new information.

The letters apply only to debt forgiven in a short sale in California, not in a foreclosure or loan modification.

Homeowners who are considering one of these options should consult a well-qualified accountant. But here's the background:

MBA BY THE BAY: See how an MBA could change your life with SFGATE's interactive directory of Bay Area programs.

Normally, when a lender forgives or cancels recourse debt, the amount extinguished is considered income and is generally subject to ordinary income tax, with a few exceptions. One is if the borrower is bankrupt or insolvent.

On the other hand, when nonrecourse debt is canceled in a foreclosure or short sale, it is never subject to ordinary income tax (although it could be subject to capital gains tax).

A loan is nonrecourse if the collateral backing the loan is the only asset the lender can seize if the borrower defaults. If the collateral is worth less than the balance due, the lender can't pursue the borrower's income or other assets.

With a recourse loan, the borrower is personally liable for the entire debt.

Recourse or not?

State laws vary but in California, a loan used to purchase an owner-occupied home with one to four units is nonrecourse.

If the homeowner refinances that loan, it generally becomes recourse (although this is subject to debate). If it was refinanced on or after Jan. 1, 2013, when a new state law took effect, the new loan remains nonrecourse, but only up to the balance remaining on the old loan. Anything over that amount is recourse.

A home-equity loan that was not used to purchase a home is almost always recourse.

But there's wrinkle: If a lender forecloses on a recourse debt outside of court, in a non-judicial foreclosure, it gives up the right to pursue the borrower for the remaining balance, called a deficiency. In California, most lenders take this route because it's quicker than a judicial foreclosure.

When this happens, the homeowner is off the hook for the deficiency but could owe income tax on the unpaid balance because it is canceled debt, Fogel says.

The acts

Until recently, homeowners haven't worried much about this tax on what many call phantom income.

When the housing crisis struck in 2007, Congress passed a law that waived the tax for most homeowners who had certain mortgage debt canceled in a foreclosure, short sale or loan modification. The waiver applied only to debt that was used to buy or substantially improve a primary residence.

The law, called the Mortgage Forgiveness Debt Relief Act of 2007, expires Dec. 31. It has been extended before, but there is no guarantee it will be again.

California passed a similar law that waived the state income tax in the same situations. It expired at the end of 2012.

Two bills in the state Legislature would extend it through the end of this year, retroactive to Jan. 1. Neither has passed.

The California Association of Realtors had supported both bills, but now considers them unnecessary, at least when it comes to short sales.

Short sale

In a short sale, a lender agrees to let a homeowner sell a home for less than the amount due on the loan.

In 2011, California passed two laws that said lenders who agree to a short sale on a one- to four-unit dwelling cannot pursue the borrower for any unpaid balance, even if the loan was recourse. The laws apply to first and second mortgages.

These laws eliminated personal liability on recourse loans after a short sale was approved in California. But it wasn't clear whether borrowers would owe income tax on recourse debt canceled after a short sale.

Sen. Barbara Boxer, D-Calif., asked the IRS for its opinion.

On Nov. 15, she disclosed that she had received a letter from the IRS saying federal tax would not be due in this situation.

The letter, from a chief in the associate chief counsel's office, says, "We believe that a homeowner's obligation ... would be a nonrecourse obligation to the extent that, for federal income tax purposes, the homeowner will not have cancellation of income."

George Runner, a member of the California Board of Equalization, asked the Franchise Tax Board for its opinion.

In a letter to Runner last week, the board's chief counsel said the same would be true for state income tax purposes.

"If you do a short sale next year and debt is forgiven, you won't have any tax liability under federal or state law regardless of whether there is any extension (of the two waiver laws). We won't even seek an extension now," says Christopher Carlisle, a legislative advocate with the Realtors association.

Fogel says he believes the IRS and tax board made the wrong decision. If borrowers owe tax on recourse debt canceled in a non-judicial foreclosure, it stands to reason they should owe tax on recourse debt canceled in a short sale, he says.

Caveat: Even if homeowners don't owe ordinary income tax on debt canceled in a short sale, they could still owe capital gains tax.

You can read the letters at http://bit.ly/IIhYCb.