Did You Lose Your House
Did your lender forgive some of your mortgage debt
because you sold it for less than it was worth? If so, you could be facing a
big tax hit.
to Foreclosure This Year?
It is IRS policy to tax forgiven debt you are personally
responsible for as if it is income. Say, for example, your credit card
company settled a $10,000 debt for 50 cents on the dollar. You'd have a debt
forgiveness of $5,000, which the IRS would count as income, just like your
The same policy held true for most mortgage debt until
2007, when Congress passed the Mortgage Forgiveness Debt Act. That ended the
liability for many homeowners -- but not all.
In general, if you lose your home to foreclosure or short
sale, where you sell your home for less than you owe, the IRS won't add
insult to injury by counting the difference as income. At least until 2012.
There are four major exceptions to the rule:
1. You did a cash-out refinance and splurged.
Many homeowners took cash out when they refinanced their
homes and used the extra dough to pay for new cars, boats or vacations. Say
you did that and then got into trouble, losing the house through a
foreclosure or short sale. Even if your lender waived the remaining debt,
the IRS will treat as income the portion of the forgiven debt that you took
out as cash and spent. Only the funds used to actually improve your home
won't be taxed. Yes, even if you spent the money on paying off your student
loans or credit cards.
The IRS' reasoning is that only the money spent on home
improvement actually added to your home's value. And that, presumably,
diminished the difference between what you owed on your mortgage and the
value of your home when it was foreclosed.
Beware: Some lenders made refinancing offers contingent on
homeowners paying off credit card debt, according to Kent Anderson, a
Eugene, Ore.-based attorney and tax expert. If you took one of those deals,
the refinance money will be reported to the IRS and you will owe taxes on
2. You have a home-equity line of credit.
During the boom years, many homeowners tapped soaring home
equity to make all sorts of consumer purchases. But the same rules that
apply to refinancings also apply to home-equity loans: The IRS will only
forgive the tax liability if the loan money was spent improving your home.
And, tax experts advise, you'll need to show receipts to prove you did.
3. You lost your vacation home or investment property.
So the market tanked and you lost your vacation home.
Unfortunately, if you didn't use it as your primary residence for at least
two of the previous five years, you're going to pay the tax man.
More common, however, may be the case of investment
properties gone sour. During the housing boom, buying homes for investment
purposes soared, accounting for 28% of all sales during 2005, according to
the National Association of Realtors. (Vacation homes made up 12%.) And many
of these purchases were made with little down payment.
When the bust hit, second home prices cratered. The median
price paid for investment properties fell 43% to $105,000 in 2009, from
$183,500 in 2005, according to NAR. For vacation homes, the median price
paid dropped 17% to $169,000.
If an investor bought a property in 2005 at the median
price and sold it in 2009, he could have run up $75,000 or so in forgiven
debt. If the investor is in the 25% income tax bracket, that would add
nearly $19,000 to their tax liability. Ouch!
4. You owned a multi-million-dollar home.
It may be hard for Americans struggling in this weak
economy to sympathize with anyone wealthy enough, at one time, to afford a
multi-million-dollar home. But owners losing one could be on the hook for a
huge tax bill.
Only the first $2 million in forgiven debt will be voided
under the relief act; all the overage is taxable as income.
So, say, for example, you're
Scarlett Johansson. You paid $7 million for
your Hollywood Hills villa in 2007. (With a 100% mortgage; this is
hypothetical, remember.) But now, you have it on the market for $4.59
Say you can't unload it, your
movies tank and you have to a short sale. (Hey, it happened to
Nicholas Cage; he went into foreclosure.) If
you sell it for $4 million, leaving a $3 million balance, the IRS would
forgive the first $2 million. But the remaining million? You better hope you
have a good accountant and a lot of deductions.
The good news? Even if you fall under any of these four
scenarios, you may have a way out, according to Anderson. "If the taxpayer
was insolvent at the time of the foreclosure, the forgiven debt can be
excluded for tax purposes," he said. "It can also be discharged in a
bankruptcy and approved by court order."
And then there is California
While most states follow the IRS
lead and don't tax most forgiven mortgage debt, California still makes you
pay. The state legislature hopes to change that before April 15, but right
now California taxpayers are legally liable for paying state income taxes on
forgiven mortgage debt.
The state, which has endured some of the worst price
declines and foreclosure rates in the nation, did follow the federal lead
when it passed the original debt forgiveness bill, but the state only
authorized the relief for the 2007 and 2008 tax years. There have been
successive legislative efforts to extend relief through 2009, but none have
One attempt at passing an omnibus "conformity" bill
resulted in a veto by Gov. Schwarzenegger for reasons having nothing to do
with mortgage debt forgiveness. The governor objected to a different
provision covering erroneous tax reporting by businesses.
Confusion and anxiety is running high, according to Rocky
Rushing, chief of staff for democratic state Sen. Ron Calderon, who is
spearheading new legislation. His office has fielded many calls from unhappy
"We've heard about tax bills in
the thousands of dollars," he said.
Mortgage Forgiveness Debt Relief
Tax Years 2014 through 2016
The federal Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from forgiven debt on their principal residence and provisions of this Act were extended to the 2014 tax year. There was a recent effort to conform California law to federal law during the 2015-2016 legislative session; however, the legislation did not pass.
You owe a debt to someone else.
They cancel or forgive that debt.
The forgiven amount may be taxable.
Debt is reduced through mortgage restructuring.
The mortgage debt was forgiven in connection with a foreclosure.
You may qualify for Federal relief.
Your debt was discharged before January 1, 2014, but on or after January 1, 2007. Similar relief for state taxes is available.
Is 2014 (and later) mortgage debt forgiveness taxable for CA purposes?
To answer that question, you must first determine:
The cancellation of debt originates from nonrecourse or recourse debt forgiveness. Generally speaking, nonrecourse debt forgiveness does not result in a tax liability from Cancellation of Debt Income (CODI). However, a portion of recourse debt forgiven in 2014 may result in CODI, and therefore may be taxable.
The debt is recourse; do any exceptions or exclusions apply? There are two common conditions that allow a taxpayer to exclude CODI from their taxable income.
The discharge occurred in a Title 11 bankruptcy.
The taxpayer was insolvent when the discharge occurred.
For more information about these and other exclusions, please see IRS Publication 4681. That publication also contains a worksheet to help calculate the extent to which a taxpayer is insolvent immediately before the debt cancellation.
Franchise Tax Board's Conformity to the IRS
As of October 16, 2015:
California law remains out of conformity with the federal statutory exclusion for certain discharges of qualified principal residence indebtedness for discharges of indebtedness occurring on or after January 1, 2014.
Federal A discharge of qualified principal resident indebtedness occurred on or after January 1, 2014, and before January 1, 2015. The mortgage debt forgiveness was extended an additional year to provide relief to qualified taxpayers.
California Any discharge of qualified principal resident indebtedness income from a discharge of qualified principal resident indebtedness that occurred on or after January 1, 2014, and before January 1, 2015, which is excluded for federal purposes. The debt may be required to be included in the taxpay