Tuesday, August 25, 2009 (SF Chronicle)
Those who lose homes may face state tax hit - byKathleen Pender
Californians who lose their homes in a foreclosure, short-sale or deed in
lieu of foreclosure this year could be hit with a state income tax on
canceled or forgiven debt.
A state law that temporarily exempted many homeowners from this tax at
the state level expired at the end of last year. Attempts to revive it have
not been successful.
The state law was similar to a federal one that exempts many homeowners
from federal tax on canceled mortgage debt. The federal law remains in
effect through 2012.
The state-tax hit could be substantial and the rules are complex. People
in mortgage trouble should consult a qualified tax professional.
Normally, when a lender forgives debt, the forgiven amount is taxed as
One exception is nonrecourse debt. On nonrecourse debt, if a borrower
defaults........ the lender can seize the collateral but can't go after the
borrower's other assets. Forgiveness of a nonrecourse mortgage generally
does not result in tax on canceled debt income.
A mortgage used to buy a home is usually nonrecourse. But if the borrower
refinances the loan and takes cash out, or takes out a home equity loan or
line of credit, that debt usually is recourse debt. Canceled recourse debt
is subject to income tax.
Exceptions to the tax also apply if the borrower is bankrupt or
Many people who got in mortgage trouble had recourse debt that, if
forgiven, would be taxed. To prevent that in some cases, Congress passed
the Mortgage Debt Relief Act of 2007.
This law temporarily waived federal tax if debt on a primary residence is
forgiven in a modification, foreclosure or short sale. The waiver only
applies to debt that was used to buy, build or improve a primary
residence. It does not apply to home-equity debt that was used to pay for
cars, credit card debt or any other purpose.
The most debt that can be exempted under the federal law is $2 million
everyone except married people filing separately, who max out at $1
million. It applies to debt forgiven in 2007 through 2012.
For state taxes, California partially conformed with the federal law for
debt forgiven in 2007 and 2008, with much lower limits. The most you could
have excluded from state taxes was $250,000 in forgiven debt ($125,000 for
married filing separately.)
Two bills, SB97 and AB111, would have extended the state-tax exemption
through 2012. The Assembly bill would have conformed fully with the
federal law. Those bills are effectively dead.
The proposal is included in another bill, AB1580, which would align a
wide range of state tax laws with federal ones. Under this provision,
California homeowners would be exempted from tax on up to $500,000 in
canceled mortgage debt ($250,000 for married filing separately) through
ChrisProvince, a real estate tax expert with Armanino McKenna in San
Ramon, has a client who owns a home in Southern California that he used to
live in and another in Santa Rosa that he lives in now. He owes about
$100,000 more than the Southern California property is worth and about
$250,000 more than the Santa Rosa home is worth. Both are recourse loans.
He is so far underwater on the Santa Rosa home he stopped making mortgage
payments in January and faces foreclosure. Since his credit is wrecked, he
plans to walk away from the Southern California home as well.
He will owe federal and state tax on $100,000 in canceled debt income on
the Southern California home.
On the Santa Rosa house, he won't owe federal tax because it is his
primary residence, but will owe state tax unless the law is extended. He
will owe about $65,000 in canceled debt tax on the two homes.
"The mortgage payments he should have been paying since January he has
been putting in the bank to pay the tax," Province says.
Without the federal tax break, he would have owed $150,000 instead of
$65,000. "This tax law has made it easier to walk away from your home,"