Originally published on Forbes.com Nov 17th, 2013
A recent IRS letter to Senator Barbara Boxer concerning the income tax implications of short sales by California homeowners seems to be provoking unqualified celebration. This headline – IRS Will Not Penalize Cali Families Losing Homes To Short Sales -is fairly typical. There was a lot of concern about this because at the end of 2013 the generous exclusion from debt discharge income when qualified principal residence mortgages are involved is set to expire. People losing their homes in a short sale is upsetting enough. The idea that they will end up with a tax bill if the bank does not pursue a deficiency judgement is really upsetting. Hence the celebration since the import of the letter is that there will be no debt discharge income when California homeowners end up doing short sales.
I hate to spoil a nice celebration, but I am going to risk it. The position that the IRS outlined in the ruling is probably good news for most people affected by it. It may not be good news for everybody, though. In order to understand why you have to understand the IRS reasoning. Here is the deal. When debt is secured by property, it is either recourse or non-recourse. Recourse means that even if the property is taken in satisfaction of the debt the creditor can still pursue the debtor. If the debt is non-recourse, the debtor can just hand the creditor the keys and walk away.
When property is surrendered in exchange for debt being repaid and the debt is recourse, the debt relief is considered proceeds of a sale to the extent of the fair market value of the property and debt discharge income for the balance. If the debt is non-recourse, all of it is considered proceeds of the sale. In 2011, the California Code of Civil Procedure was amended to add Section 580e which provides that:
No deficiency shall be owed or collected, and no deficiency judgment shall be requested or rendered for any deficiency upon a note secured solely by a deed of trust or mortgage for a dwelling of not more than four units, in any case in which the trustor or mortgagor sells the dwelling for a sale price less than the remaining amount of the indebtedness outstanding at the time of sale, in accordance with the written consent of the holder of the deed of trust or mortgage…
The effect of that section is to make just about all California home mortgages non-recourse. Hence there will never be debt discharge income generated by them. Probably under the most common scenarios, this rule will work out to be taxpayer-friendly. If your home is being foreclosed because the value plummeted after you bought it you probably have a loss – a non-deductible loss. Even if you have a gain, for whatever odd reason, you will likely qualify for exclusion up to $250,000 or $500,000 if you are married.
There are situations where this rule might work against the taxpayer, particularly those who borrowed against property after it appreciated. There are various exceptions to recognizing debt discharge income, such as the insolvency exception. These will no longer be available. There will be a gain that is inescapable to the extent that it is not covered by the principal residence exclusion. So look closely at your facts before you throw a party to celebrate this ruling.
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