Short Sale Debt Foregiveness

If residential real estate is sold when there is not enough funds to satisfy payoff of the entire mortgage, the seller will need to get approval from the lender for a short sale. When a lender approves a short sale, the seller is able to payoff a portion of the debt owned. The difference between the full payoff and the amount received by the lender is defined as "debt foregivness". In the past,the amount of the debt foregiveness was taxable to the seller as debt discharge income. Today both the Federal and State of California have enacted legislation that foregives the taxpayer of taxes owned. Federal and State tax laws are somewhat different on this subject.

Federal 

The passage of the Mortgage Foregiveness Debt  Relief Act of 2007  states a taxpayer does not have to pay federal income tax on bebt foregiven for a loan secured by a qualified principal residence.

This tax break applies to debts discharged from January 1, 2007 to December 2009. Qualified principal residence indebtedness is debt incurred in acquiring, constructing, or substantially improving the residence (up to $2 million for refinances).

For purposes of calculating capital gains, any debts discharge from income under the new law must be subtraced from the basis of the taxpayer's principal residence(but not below zero).  However, tax payers may generally exclude from capital gains income up to $250,000 (or $500,000 for married couples filing jointly) for properties owned and used as their pricipal resience for the last two of the last five years.

State of California

California now partially conforms personal income tax law to the federal amendments made by the Mortgage Foregiveness Debt Relief Act of 2007 allowing an exclusion from gross income for discharge of an individual's qualified principal residence indebtedness.  However, the California exclusion is limited to indebtedness discharged in 2007 and 2008 calendar years, while the federal exclusion applies to indebtedness discharged in 2007 through 2009.  Also the amount of the California exclusion is limited to $250,000 ($125,000 in the case of a married individual filing separtely), and "qualified principal residence indebtedness" is defined for the purpose of the California exclusion to mean an individual's qualfied acquistion indebtness of up to $800,000 ($400,000 in the case of a married individual filing separately) rather than the $2 million ($1 million in the case of a married individual filing separately) provided under fedral law.