August 6, 2015 update: Congress extended the Mortgage Forgiveness Debt Relief Act to cover short sales, foreclosure sales and cramdowns through the end of 2014. If your seller had debt discharged in this manner in 2014, they are eligible to exclude this principal discount from their taxable income, with the exception of cash-out refinancing. The exemption is not automatic — it must be claimed as exempt debt cancellation. Refer to IRS Publication 4681 for more.

Currently, there is no federal legislation pending to further extend the Mortgage Forgiveness Debt Relief Act in 2015. 

As of July 2015, California’s legislature is considering Assembly Bill 99, which would extend the state tax exclusion of discharged qualified principal residence indebtedness from an individual’s income if that debt was discharged before January 1, 2015. This bill is currently suspended for budgetary review, and first tuesday will update this article once a decision is published.

The Mortgage Forgiveness Debt Relief Act expired at the end of 2013. But that doesn’t necessarily mean all short sellers are in trouble this year.

From 2007-2013, short sellers nationwide were able to skip reporting the difference between their short sale amount and the balance owed on their mortgages as taxable income. Now, homeowners seeking a short sale have to contend with an extra tax bill for the perceived “gain” in income.

For example, consider a homeowner whose current fair market value (FMV) of their home is $300,000. However, they owe $400,000 (33% over FMV – the nationwide average for underwater homeowners, according to CoreLogic) on their mortgage. They receive lender approval to sell their home at a short sale for $300,000. Thus, the difference of $100,000 is reported as taxable income. If they fall into the 25% tax bracket (as most Californians do), they will owe a tax bill of $25,000 for their short sale.

This is bad news indeed for our nation’s underwater homeowners. However, California’s roughly 900,000 underwater homeowners have state law in their corner: nonrecourse debt on purchase-assist financing for one-to-four unit owner-occupied homes. [26 Code of Federal Regulations §1.1001-2; Internal Revenue Code §108; Calif. Revenue & Taxation Code §17144.5]

Nonrecourse debt is not taxable, therefore many Californians pursuing a short sale in 2014 have nothing to worry about from the expiration of the Mortgage Forgiveness Debt Relief Act. We repeat: a majority of Californians have nothing to worry about from the expiration of the Mortgage Forgiveness Debt Relief Act.

However, not all distressed California homeowners are immune from the sunset of this tax benefit. Nonrecourse protections do not apply to recourse debt. Most critically, this includes:

  • cash-out refinance loans; and
  • Home Equity Lines of Credit (HELOCs).

Bottom line: inform clients about the potential tax implications of their short sale (or the curative possibilities of a strategic default, which will become more common between 2020-2025). Seeking a short sale may not be the best financial move for homeowners with recourse debt, but  it’s better to know the rules now than face a crippling financial surprise come tax-time.