While it is true that short sales are no longer such a dominant segment of the real estate market, they are still around and, many suspect, will continue to be for some time. It is a pleasure to report, then, that we have recently received some good news for California short sellers. In short, California short sellers of residential properties (1 - 4 units) will continue to be protected from taxation on the "phantom income" received in a short sale.
A brief history is in order. "Phantom income" refers to the amount of debt that is forgiven when a lender is willing to accept less than the full amount owed. If you owed $200,000 on your mortgage, and the lender allowed a short sale for $180,000, you would have received $20,000 in phantom income. (Phantom, because you never got to lay your hands on it.) Normally, under both state and federal law, forgiven debt is taxable as income. (If it weren't, every CEO would arrange to be paid in the form of a loan that would later be forgiven.)
In the face of a crumbling economy and a tsunami of short sales, Congress passed the Mortgage Forgiveness Debt Relief Act of 2007 which provided that there would not be taxation on debt forgiveness in the short sales of qualified principal residences. California adopted legislation to conform to the Federal policy. In neither case, however, was the legislation permanent. The California version expired at the end of 2012. The Federal provision expires at the end of 2013. The respective legislatures - being busy with so many other things - have given no signs that there will be further extensions.
So, does this mean that short sellers will once again face the prospect of being taxed on phantom income? The answer is "no" in the case of most California short sales. This was made clear recently in an IRS letter to California Senator Barbara Boxer and in a letter subsequently released by the Franchise Tax Board (California's version of the IRS).
The IRS letter noted that forgiven debt is not considered taxable if the debt obligation is nonrecourse. If a debt is recourse, the lender is owed the difference - a deficiency - if the debt is not paid in full. In many states, mortgage debt is recourse debt. If a foreclosure auction does not generate enough to satisfy the outstanding debt, the lender may pursue the borrower for the difference. In California, though, some mortgages (e.g. for the purchase of a principal residence) are nonrecourse. An auction pursuant to a trust deed foreclosure will be full satisfaction of the debt, even if it garners less than the balance owed. There is no deficiency judgment; there is no recourse.
In its letter to Senator Boxer, the IRS noted the following: "In 2011, California enacted an anti-deficiency provision under section 580e of the (Code of Civil Procedure), which generally prohibits a lender who holds a deed of trust on a homeowner's principal residence from either claiming a deficiency or obtaining a deficiency judgment from the homeowner after agreeing to a short sale." Thus, "We believe that a homeowner's obligation under the anti-deficiency provision of section 580e of the CCP would be a nonrecourse obligation to the extent that, for federal income tax purposes, the homeowner will not have cancellation of indebtedness." There will be no taxation of short sale phantom income.
Responding to inquiry on the same matter, the Franchise Tax Board said, "Since California conforms to the relevant portions of the federal tax law governing the forgiveness of nonrecourse and recourse indebtedness, California would follow the federal treatment for the CCP section 580e transactions."
That's good news for most Californians who may be facing a short sale.