Homeowners who lost homes in foreclosure or sold property in a short-sale in 2009 will incur an unexpected state tax on any discount or underbid of a recourse mortgage loan. California, unlike the IRS, currently considers forgiven mortgage debt on recourse loans to be income subject to state taxes. This extra “income” for the homeowner is disclosed to the California Franchise Tax Board (FTB) by the lender who discounts or reduces the amount of a second mortgage or home equity line of credit or refinancing, or who underbids or accepts an underbid on a recourse loan at the foreclosure sale.

Neither state nor federal taxes on discharge of debt apply to non-recourse loans (i.e. mortgage loans taken to purchase the buyer’s principle residence). The federal government has exempted recourse loans until 2012. Homeowners who declare insolvency or bankruptcy are also exempt from taxation. The state legislature did not tax recourse debt relief in 2007 or 2008, but it has not yet extended the recourse-exemption through 2009. At the moment, the legislature is unlikely to grant this extension before the April 15 tax deadline. If the 2009 exemption is granted later, taxpayers will be able to apply for a refund.

first tuesday take: In recent years, many homeowners refinanced their homes or obtained equity loans, both activities classified as recourse loans. These owners then made a fateful decision to sell their homes and negotiate a short payoff (a discount) on their recourse loan rather than defaulting and forcing the lender to buy the home at foreclosure. They now find themselves the butt of an unfortunate joke (you lost everything you had in your home and, congratulations, you now owe state income taxes of approximately 10% on the discount—with no offset for your losses).

The taxing of homeowners who negotiate a short payoff on a recourse loan is a fool’s tax, contrary to the homeownership goals of both owners and policymakers. The tax penalty falls upon those owners who choose not to default on an underwater refinanced or equity loan. Conversely, defaulting allows the owners to rid themselves of an underwater property, generally without taxation (since the lender usually makes a full credit bid).

As a result, the legislature punishes those homeowners who intentionally accommodate lenders by negotiating a short sale and payoff to sell their homes at current market prices (a behavior that the state and federal government have both worked to encourage). The tax-free alternative is for the owner to default and force the lender to foreclose and resell the property 12 months later as real-estate-owned (REO), at a far greater loss for the lender.

Keep in mind that purchase-assist loans for buyer-occupied 1-4 unit residential property are non-recourse loans in CA. Thus the owner incurs no discharge-of-indebtedness income, state or federal, when the lender discounts the principle on the sale of a home (called a short payoff). For a short payoff of a recourse loan, the seller’s agent should promptly advise the seller of the negative tax consequences of his sale, even though he has no legislated duty to do so. Surprises to clients about facts or law known to the agent produce no referrals. [For more information on the state and federal tax aspects of non-recourse and recourse loans, see the February 2009 first tuesday article The Taxation of Short Sale Discounts and Foreclosures; for information on any and all legislation currently under consideration to exempt homeowners from this tax, see the latest Sacramento Gossip.]

Re: “Hefty tax bill may hit those who lost home” from The San Diego Union Tribune