Milpitas North San Jose Berryessa Real Estate News

Short sales raise a number of complex tax issues for sellers.  In a short sale in which the lender agrees to cancel or "forgive" all or a certain portion of the debt that is owed, the IRS and FTB may treat that cancelation of debt as income for the seller.  This income is taxed at the person's tax rate for ordinary income.  As you can imagine, that could lead to severe tax consequences for persons involved in a short sale, especially in an area with substantial price declines.

However, many short sellers, fortunately, are not likely to have any - or at least a much lower - tax liability from the cancelation of debt.  This is due to laws passed both on the federal level and in California that offer tax relief for cancelation of debt income in short sales and also due to the insolvency provision of the tax laws.

Under the federal Mortgage Debt Relief Act of 2007, a seller involved in a short sale could see a significant reduction in or even pay no tax on his or her canceled debt.  If the property involved in the short sale is the taxpayers principal residence and the mortgage on the property was taken out to acquire, construct, or substantially improve the residence, then the canceled debt will not be subject to taxation.  A refinance of the property may still be exempt from debt relief income tax, but if any cash was taken out in addition to the original mortgage, that cash will only be exempt to the extent it was used to substantially improve the property.  So, for example, if a seller refinanced but took out $100,000 to pay off credit cards and buy a new car, that portion of the debt would remain taxable.  The cancelation of debt income exemption is capped at $2,000,00 or $1,000,000 for a married person filing separately.

California law mirrors the federal law but has lower limits for the amount of cancelation of debt income that is exempt: either $500,000 for most persons or $250,000 for a married person or person in a registered domestic partnership filing separately.  Also there is a cap on the overall amount of indebtedness eligible for tax relief under California law of $800,000 for most persons and $400,000 for a married person filing separately.

Both laws are scheduled to terminate at the end of 2012.