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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 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!