Short sales in California are generally not subject to state or federal income tax for cancellation of debt. The Franchise Tax Board (FTB) issued a letter yesterday stating that, as nonrecourse obligations, short sales in California are not subject to state income tax for cancellation of debt. The FTB’s position conforms with the federal treatment of short sales stated in an IRS letter as we previously reported on November 15. These letters will provide welcome relief for short sale sellers given that the tax break for a qualified principal residence under the federal Mortgage Forgiveness Debt Relief Act of 2007 will expire at the end of this year, and similar protection under California law already expired in 2012. The FTB letter includes transactions that closed in 2012 but, as always, sellers should consult with their own tax professionals.
According to the recent FTB letter, “a California taxpayer would not have cancellation of indebtedness where the taxpayer was involved in a short sale pursuant to CCP section 580e.” Section 580e of the California Code of Civil Procedure (CCP) generally protects borrowers from owing a deficiency after a short sale of a residential property with one-to-four units, including both first and junior trust deeds. Exceptions include fraud, waste, cross-collateralized loans, and borrowers that are corporations, LLCs, or limited partnerships. For more information, C.A.R. members may refer to our legal article on Short Sale Deficiencies.
As with the IRS letter, the FTB letter states that even if no cancellation of debt income is owed, a taxpayer may nevertheless have capital gains to the extent that the outstanding debt exceeds the tax basis for the property. A principal residence, however, is generally excluded from capital gains tax up to $250,000 for single taxpayers and $500,000 for married couples filing joint returns (under 26 U.S.C. § 121).
LEGAL Q&A UPDATE: C.A.R.’s Legal Department provides REALTORS® with a wide range of legal articles. Three of our newly revised legal articles available at qa.car.org are as follows:
•Transfer Disclosure Statement Law: Updated to include disclosure of construction defect claims under Senate Bill 652 starting on July 1, 2014.
•Contingencies and Contingency Removal: Added a discussion of a buyer’s right to cancel a contract under an inspection, loan, appraisal or other contingency.
•Smoke Alarm Requirements: Revised to reflect recent changes to the specification requirements for smoke alarms.
Realegal® is published by the CALIFORNIA ASSOCIATION OF REALTORS®, a trade association representing more than 155,000 REALTORS® statewide. C.A.R. does not in any way endorse or sponsor any product or service or vendor mentioned herein unless expressly stated.
Please know that on a case by case basis the seller may be subject to capital gains tax as the forgiven debt will not be considered income but may be consider money realized and thus subject to capital gains tax. Every seller should seek the advice of a CPA to determine their basis in the property and every realtor should be careful to not make blanket general statements about non-tax liability.
Aaron Zapata is the broker-owner of Zapata Realty, Inc. located in Yorba Linda, CA. He has been a licensed broker for over a decade. His growing practice includes residential and apartment sales in Southern California.
Aaron holds a degree in Biblical and Theological studies from BIOLA University and a Masters of Business Administration (MBA) from Cal State Fullerton. He has been quoted by the Los Angeles Times, Orange County Register, and the Associated Press and is an author and speaker. He is also maintains designations and memberships with nearly a dozen organizations aimed at raising the standards and ethics in the real estate industry. Although ranked in the top 1% nationwide, he gives each client his focused attention with the simple purpose of doing what is best for them. Nearly all of his business comes from referrals from his satisfied clients.
Aaron lives in Yorba Linda with his wife Dawn. They have been married for 18 years and have a 10 year old named Levi, a 7 year old named Malachi, and they have a Beagle name Sadie. He is an active member of Friends Church in Yorba Linda as a Board Member, and the Chamber of Commerce where he serves as the Chamber’s Network Connection President. This past summer he travelled to India with his oldest son to care for and educate the poorest of the poor.