Tax Implications of a Short Sale: 1099C, California Taxes & Federal Taxes
February 19, 2010 by admin · Leave a Comment
*Note* The question of the tax implications of a short sale came up this morning during my appearance on “These Days” with Maureen Cavanaugh on KPBS radio. As there seems to be quite a bit of confusion and misinformation with regard to this topic, I wanted to address it here on our blog. The following is excerpted from the Short Sale FAQ page of www.battiata.com, which can be accessed in its entirety by clicking here:
With regard to state and federal taxes, however, here is the excerpt from Battiata.com -
Q: Will I have to pay federal taxes on the money my lender loses in the short sale?
Answer: There are several different scenarios with regard to whether or not you will owe federal income taxes on the loss the lender takes in a short sale.
When you do a short sale, your lender is agreeing to settle the debt on the property for less than the amount they are owed. The IRS therefore allows them to write off this loss, which is why your lender will send you a 1099-C after the short sale.
The IRS considers “debt relief” to be income for tax purposes. In other words, if your lender writes off $50,000 on your short sale, they will send you a 1099-C for that amount, and you would include that when you file your income taxes. The “C” stands for “Cancellation of Debt” and the law says cancelled debt is taxable as income.
There are however a few exceptions that most people who do a short sale qualify for that exclude them from having to pay taxes on their short sale.
Thanks to the Mortgage Tax Debt Relief Act that George W. Bush signed into law in January of 2008, homeowners who do a short sale on their primary residence, and have a purchase money loan (in other words, they have not pulled cash out of their home with a cash-out refinance) pay no taxes on the loss that their lender incurs in a short sale.
Homeowners who have pulled out cash from their home but have put that money back into their home to “substantially improve” their home, also are excluded from taxes on the short sale.
All other short sale scenarios – if you pulled cash out on your primary residence but spent it something other than upgrading your home or if you are doing a short sale on a second home or investment property – result in a taxable event unless you qualify for the “Insolvency” exclusion.
The IRS does not require you to pay taxes on the loss the lender takes in a short sale if, at the time of the short sale, you are insolvent. Insolvency means your debts (including your mortgage) exceed the value of all your assets. In other words, if, at the time of the short sale, you have more debt than you do money or assets, you are considered insolvent.
Many people who find themselves facing a short sale are in exactly this situation and are thus excluded from paying taxes on a short sale. We recommend you check with your CPA or accountant or go to the IRS website and look up IRS Form 982, which is the IRS form for debt relief and short sales. The IRS gives an explanation of “Insolvency” on this form.
Finally, the time period for The Mortgage Tax Debt Relief Act was originally only slated to go until the end of 2008, however it has now been extended to the end of 2012.
Q: Will I have to pay CA state taxes on the money my lender loses in the short sale?
Answer: California has passed its own version of the federal Mortgage Tax Debt Relief Act. It is Senate Bill 1055, which conforms to the federal law described in detail above, but applies to California state income taxes on a short sale.
There are differences between the state and federal law. For example, the term of the California law was only until the end of 2008. As of Jan 2009, this law is no longer in effect.
However, CA Revenue & Taxation Code Section 17131 provides that, unless there is some specific California statute to the contrary, California law tracks federal law on what income is excluded from taxation. Since there is currently no specific California law on this issue, short sales do not produce taxable income under California law as long as the Federal Mortgage Tax Debt Forgiveness Act is in effect (until the end of 2012).
With this said, we recommend you review your specific tax scenario with your CPA or accountant and have them answer any tax questions that you have. We are not tax advisors and do not dispense tax advice.
