Homeowners worried about being taxed for their discount when short selling homes can relax. By federal mandate, debt forgiven by lenders in the short sale process is off-limits to the Internal Revenue Service (IRS) through 2012. Although this “extra income” is considered taxable by the state government, legislation is under consideration that would exclude it. Furthermore, even if that legislation fails, State Senate Bill 97 (also currently under consideration) would prohibit any interest or penalties for failure to pay. Investors who do not own their home as a primary residence are not eligible for these tax exclusions.

first tuesday take: The simple fact behind this article is that sellers in the short payoff of a nonrecourse loan do not incur taxable “discharge-of-indebtedness” income if the property is sold or disposed of by foreclosure or a deed-in-lieu. In a short sale involving the discounted payoff of a nonrecourse (purchase-assist) loan, the entire amount of the loan is reported to the IRS by the seller as the price realized on the sale to the buyer. The owner’s cost basis is then subtracted from the price realized (the loan amount) to set his profit or loss to be reported on the sale.

The lender or carryback seller’s source of recovery on a nonrecourse loan is always limited to the security, a situation in which deficiency judgments are not allowed (called purchase-money paper). All nonrecourse notes secured by real estate are subject to California anti-deficiency laws. As this article indicates, Californians in short sales on non-recourse purchase-assist loans can look forward to enjoying that protection throughout the upcoming years as well.

A parallel issue: Bankruptcy judges are not permitted to cram down mortgages in California. As a result, lenders have no incentive, except profit or loss, to accept a payoff at a discount to facilitate a short sale. A mere 3.25% of sales in California in the first quarter of 2009 were short sales. Unless the courts are granted cramdown authority, owners will rarely have any reason to consider the tax consequences of a short sale discount—or to look forward to any discount at all should they decide to keep their home with its negative equity encumbered by a corresponding dead-end mortgage debt.

Re: “Home front: Selling short can be scary”, from the Sacramento Bee