The California Association of REALTORS® (C.A.R.) announced on Wednesday that it received a letter from the California Franchise Tax Board (FTB), obtained by Board of Equalization member George Runner, clarifying that California families who have lost their home in a short sale are not subject to state income tax liability on debt forgiveness “phantom income” they never received in a short sale.

Last month, in a letter to California Senator Barbara Boxer, the Internal Revenue Service (IRS) recognized that the debt written off in a short sale does not constitute recourse debt under California law, and thus does not create so-called “cancellation of debt” income to the underwater home seller for federal income tax purposes. Following the IRS’s clarification, C.A.R. sought a similar ruling by the California FTB. With the FTB’s clarification, underwater home sellers are now assured that they are not subject to state income tax liability, rescuing tens of thousands of distressed home sellers from California tax liability for debt written off by lenders in short sales.

“We are pleased with the recent clarifications issued by the IRS and the California Franchise Tax Board, which protect distressed homeowners from debt relief income tax associated with a short sale in California,” said C.A.R. President Kevin Brown. “We would like to thank Senator Boxer and BOE member Runner for their leadership in obtaining this guidance from the IRS and FTB. Distressed California homeowners can now avoid foreclosure or bankruptcy and can opt for a short sale instead, without incurring federal and state tax liability, even after the Mortgage Forgiveness Debt Relief Act of 2007 expires at the end of this year.”

One of the major successes Congress reached in the “fiscal cliff” negotiations at the end of 2012 was the extension of the Mortgage Forgiveness Debt Relief Act for another year. The measure will continue to exempt from taxation mortgage debt that is forgiven when homeowners and their mortgage lenders negotiate a short sale, loan modification (including any principal reduction) or foreclosure.

While debt relief had been extended at the federal level, the state exemption expired at the end of 2012. In order to conform state law to the federal law that recently passed extending mortgage debt forgiveness, C.A.R. sponsored Senate Bill 30 (Calderon, D-Montebello) so California homeowners on the brink of foreclosure could get much-needed debt relief. That measure has stalled at the state level.

“Senator Boxer’s request to the IRS to provide guidance on whether mortgage debt forgiveness in a lender-approved short sale would be taxable and the subsequent rulings by the IRS and California FTB help clarify the state income tax status of distressed home sellers in California. Many have been worried about it and have contacted our association seeking clarification. We are glad the issue has been resolved,” said Carolyn Miller, president of the Silicon Valley Association of REALTORS® (SILVAR).

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