Short Sales and Cancellation of Debt (COD)
In our November 2013 edition of Tax News, we looked at Foreclosures and Mortgage Forgiveness Relief which explained that when there is a foreclosure how the foreclosure is reported and you determine the amount realized from the transaction depends on the FMV of the property and whether the debt on the property is a recourse debt or a nonrecourse debt.
The IRS publication 4681, Canceled Debt, Foreclosures, Repossessions, and Abandonments (For Individuals), simply states, “Debt for which you are personally liable is recourse debt. All other debt is nonrecourse debt.”
When it comes to determining if a debt is recourse or nonrecourse what is important is what the lender can do to collect. The answer will depend on several factors, most importantly you need to look at where the lender will need to look to enforce collection of the debt, as each State may have its own set of laws or procedures the lender must follow. Indebtedness that appears on its face to be recourse may be treated as nonrecourse because of some provision of State law. For example, in California, section 580b of the California Code of Civil Procedure provides that indebtedness incurred to purchase a home in California is non-recourse debt. The law prohibits a deficiency judgment in connection with indebtedness that was incurred to purchase a one-to—four-family residential property that is actually owner-occupied. Consequently, purchase money financing on one-to-four-family residential property that is owner-occupied is nonrecourse indebtedness, notwithstanding the owner-occupant's apparent liability for the indebtedness.
Section 580e of the Code of Civil Procedure also addresses mortgages. This section was added in 2010 and it prohibits a deficiency judgment on specific agreed to "short sales" (allowing the defaulter to sell the house at below cost, and the lender accepting the proceeds as payment in full). In 2011, section 580e was amended to expand its provisions in order to mitigate the impact of the ongoing foreclosure crisis and to encourage the approval of short sales as an alternative to foreclosure.
According to an IRS Information Letter dated September 19, 2013, the IRS has determined under the 2011 changes to the California Code of Civil Procedure Section 580e, that California taxpayers who sell their principal residences in a short sale for less than what is owed on the home are relieved of incurring cancellation of indebtedness income, if the lender agrees to the short sale as full consideration of the mortgage debt, and there will be no cancellation of indebtedness income.
The IRS’s letter answered the question regarding whether a homeowner would have taxable cancellation of indebtedness (COD) income when the lender approved a short sale considering California’s Code of Civil Procedure (CCP) section 580e. The letter finds California’s anti-deficiency provision under section 580e of the CCP which generally prohibits a lender who holds a deed of trust from either claiming a deficiency or obtaining a deficiency judgment from the homeowner after agreeing to a short sale, treats the homeowner’s obligation as a nonrecourse obligation for tax purposes.
This means in California, upon a lender’s acceptance of the short sale any CCP 580e qualifying cancellation of indebtedness income is nontaxable nonrecourse debt. CCP 580e does not apply to all short sales. In addition to other restrictions this law states it does not apply if the trustor or mortgagor is a corporation, limited liability company, limited partnership, or political subdivision of the state.
California conforms to the relevant portions of the federal tax law governing the forgiveness of nonrecourse and recourse debt, so if the lender agrees to the short sale as full consideration of the mortgage debt, for tax purposes, the loan will be nonrecourse thus, there is no cancellation of indebtedness income for California tax purposes.
Capital Gains Income Not Excluded
Even though California taxpayers may not have cancellation of indebtedness income on the short sale of their residences, they may incur capital gains income on the transactions, which could be taxable. We encouraged taxpayers to refer to IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments and IRS Publication 523, Selling Your Home.
We updated our website to include information about mortgage debt relief for taxpayers who sold their principal residences through a short sale in 2013. We advise taxpayers with transactions involving debt cancellation to consult with a tax professional.
This guidance is relevant to California taxpayers that:
- Incurred short sales in 2013 since California’s Mortgage Debt Relief Act expired at the end of 2012.
- Incurred cancellation of indebtedness income from a short sale in 2011 and 2012 from exceeding the California Mortgage Debt Relief ceiling amounts.
Form 540X – Claiming Mortgage Forgiveness Debt Relief for a Previously–filed Tax Return
If you already filed your tax return, file a California Form 540X, Amended Individual Income Tax Return, in order to properly report the short sale as nonrecourse debt.