Last week, the California Association of Realtors (“CAR”) in their weekly newsletter I receive, CAR Newsline, publised a revised Question & Answer article on “Taxation of Foreclosures and Short Sales. Below, I have reprinted four of the questions and answers for you. If you would like a copy of the entire article please send me your email address and I will get you a copy with no strings attached. I would have put a link to the article in this post but unfortunately it is on the CAR site which requires password access.
Q 1. Are foreclosures, deeds in lieu of foreclosure, and short sales subject to federal tax income taxation?
A Yes. However, the income is taxed differently depending on several factors, including whether there was a foreclosure, a deed in lieu of foreclosure given to the lender, or a short sale (a sale where the lender agrees to reduce the amount owed in order to facilitate a sale), and whether the underlying debt is ?recourse? (the borrower is personally liable for the debt) or ?nonrecourse? (the borrower is not personally liable for the debt).
For federal income taxation as a result of foreclosure, see generally 26 U.S.C. §§ 1001 through 1016. For federal income taxation of short sales, see generally 26 U.S.C. §§ 61, 108 and 1001 through 1016.
Q 3. How does the owner receive “income” from a foreclosure or a deed in lieu of foreclosure?
A A foreclosure proceeding, whether through a trustee sale or judicial foreclosure, and a deed in lieu of foreclosure given to the lender are treated the same as a sale for income tax purposes. The foreclosure or deed in lieu of foreclosure is reported on the taxpayer’s tax return as a sale or exchange in the year the foreclosure is finalized or the deed in lieu of foreclosure is given to the lender.
In a foreclosure or deed in lieu of foreclosure, the owner can receive “capital gain or loss” as in any other sale of real property (i.e., be subject to capital gains taxation or receive a credit for a capital loss). Additionally, the owner can receive “forgiveness of debt” income. This is also referred to as “cancellation of debt” income. Whether the owner is subject to taxation on this income may depend on whether the debt is “recourse” or “nonrecourse.” If the debt is a recourse debt, the owner may be deemed to have received taxable income in the amount of debt that is forgiven by the lender (except in certain situations discussed below where the owner will not be taxed). If the debt is nonrecourse debt, there is no taxable income from forgiveness (or cancellation) of debt, but the owner may be still be subject to capital gains taxation.
Q 10. Are there any other exemptions from the taxation of cancellation of debt income?
A Yes. There are four other circumstances, in addition to what was discussed in Question 9 where the taxpayer can get relief from taxation on cancellation of debt income:
(1) The taxpayer is insolvent (the taxpayer’s debts exceed their assets, but the cancellation of debt is forgiven only to the extent of the insolvency);
(2) The debt is discharged as part of a bankruptcy proceeding;
(3) The debt discharged is qualified farm indebtedness; or
(4) The debt discharged is qualified business indebtedness.
For all of the above, any reduction in indebtedness will be applied to reduce the taxpayer’s basis in the property.
(26 U.S.C. §§ 108(a), 108(b), 108(c) and IRS publication 908.)
Note, however, it is likely that many taxpayers currently subject to cancellation of debt income will qualify for the insolvency exemption from taxation. Taxpayers should be advised to speak with their own tax advisors as to whether they meet the insolvency exemption.
Q 14. Does California follow the debt relief rules set forth above?
A Recently passed California law, SB 1055, conforms California Revenue and Tax Code Section 17144.5 to federal law with the following exceptions:
1. The maximum amount of acquisition indebtedness is reduced to $800,000 for couples filing jointly and $400,000 for individual filers;
2. The maximum amount of debt relief income that can be forgiven is $250,000 for couples filing jointly and $125,000 for individual filers; and
3. California’s debt relief statute applies to property sold on or after January 1, 2007 and before January 1, 2009.