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Here are some simple guidelines for how and when to report shortsale or foreclosure sale discounts, called discharge-of-indebtedness income by the IRS and cancellation of debt by the Franchise Tax Board:

For the sale of your principal residence. If you are reporting a discount on a purchase-assist or improvement loan, the discount produces income which your lender will report to the IRS by filing a 1099-C. However, discharge of indebtedness income “earned” through December 31, 2012 is excluded from taxable income under current federal and state mortgage debt relief laws. Check out //www.ftb.ca.gov/aboutFTB/newsroom/Mortgage_Debt_Relief_Law.shtml for federal and state debt relief limits.

For the sale of a property other than your principal residence. If you are reporting a discount on a loan other than a purchase-assist or improvement loan, the discount will be subject to ordinary income tax rates— unless the loan has nonrecourse purchase-money status under California antideficiency law.

The most common mistakes made when California homesellers report the discharge-of-indebtedness income on shortsales or foreclosure sale discounts are:

  • lender error in the discounted amount of 50% on 1099-C (cancellation of debt) forms lenders filed;
  • shortsale homesellers failing to properly report by using an IRS Form 982;
  • homesellers improperly claiming insolvency under Internal Revenue Code §108 to exclude discharge-of-indebtedness income; and
  • homesellers failing to report and include IRS Form 982 disclosing the discharge-of-indebtedness income.

These mistakes are easily remedied by hiring an accountant familiar with the rules regarding discharge-of-indebtedness income. Need a reference? Contact me today!