Understanding the tax treatment of cancelled mortgage debt

I read an excellent article today on the tax treatment of cancelled mortgage debt by an excellent Real Estate writer, Kenneth R. Harney.

In a nutshell, if debt is forgiven due to a short sale, foreclosure or loan modification, the lender sends the borrower a 1099C at the end of the year. If the debt was forgiven on your principal residence and you have only used the funds to purchase, build or improve your home, it's probably not taxable income. It would be taxable if you refinanced and pulled out money to buy a Tesla. Check out IRS Form 982 and Publication 4681 for more technical details.

The link to this great article is: http://articles.latimes.com/2011/mar/13/business/la-fi-harney-20110313

Enjoy! I have a great real estate attorney and C.P.A. to refer if you need more help. Just let me know.

Judy Clarke
The Clarke Team
Bay Area Real Estate
650-489-5399
sold@clarketeam.com

California won’t tax forgiven mortgage debt

Governor Schwarzenegger on Monday signed SB 401 (Wolk) into law providing distressed homeowners with state tax exemption on debt forgiven in a short sale, foreclosure, or loan modification. Effective immediately, this bill generally aligns California's tax treatment of mortgage debt relief income with federal law. For debt forgiven on a loan secured by a qualified principal residence, borrowers now will be exempt both from federal and state income tax consequences. The tax exemptions apply, with certain restrictions, to debts discharged from 2009 through 2012. Californians who have already filed their 2009 tax returns may claim the exemption by filing a Form 540X amendment.

Taxpayers who do not qualify for the above exemptions (e.g., second home or rental property) may nevertheless be exempt under other provisions. Most notably, taxpayers who are bankrupt are exempt from debt relief income tax. Also, taxpayers who are insolvent are exempt from debt relief income tax to the extent their current liabilities exceed current assets.

NO MORE STATE TAX ON FORGIVEN DEBT

Distressed homeowners no longer have to pay California state income tax on debt forgiven in a short sale, foreclosure, or loan modification. Enacted into law yesterday, Senate Bill 401 generally aligns California's tax treatment of mortgage debt relief income with federal law. For debt forgiven on a loan secured by a "qualified principal residence," borrowers will now be exempt from both federal and state income tax consequences. The existing federal exemption is for indebtedness up to $2 million, whereas the new California exemption is for indebtedness up to $800,000 and forgiven debt up to $500,000.

"Qualified principal residence" indebtedness is defined as debt incurred in acquiring, constructing, or substantially improving a principal residence. It includes both first and second trust deeds. It also includes a refinance loan to the extent the funds were used to payoff a previous loan that would have qualified.

The tax breaks apply to debts discharged from 2009 through 2012. Californians who have already filed their 2009 tax returns may claim the exemption by filing a Form 540X amendment. Taxpayers who do not qualify for the above exemptions (e.g., second home or rental property) may nevertheless be exempt under other provisions. Most notably, taxpayers who are bankrupt are exempt from debt relief income tax. Also, taxpayers who are insolvent are exempt from debt relief income tax to the extent their current liabilities exceed current assets.

For more information about mortgage forgiveness tax consequences, go to California Franchise Tax Board's Mortgage Forgiveness Debt Relief Extended webpage and the Internal Revenue Service's Mortgage Forgiveness Debt Relief Act and Debt Cancellation webpage. The full text of Senate Bill 401 is available at www.leginfo.ca.gov.