Getting Rid of an Underwater Property: What You Need to Know About Short-Sales, Deficiencies, and Tax Liability in California

The housing crash has left many people wondering what to do with homes that are now so far underwater they may never recover their former equity. To add insult to injury, many of these homeowners cannot afford to pay the mortgage on these underwater homes. This combination of factors has led many people to explore their options in an effort to unload their property. In these types of situations there are really only two options, short-sales or foreclosure.

What is a short-sale? A short-sale is when a person sells their property for less than the current mortgage owed on it. To do this, the seller must receive bank approval. When considering a short-sale in California it is important to know the laws concerning deficiencies and debt forgiveness. It used to be that a person who entered into a short-sale agreement to sell their property may still be liable for the deficiency between what the original loan amount and the short-sale price. I have seen this happen in the past and it was especially worrisome when the homeowner only had one mortgage and would otherwise have been protected from a deficiency judgment if they had only let the property go to foreclosure. That protection comes from California’s anti-deficiency statutes, but more on those statutes in a later blog. In an effort to protect homeowners from a deficiency liability post short-sale, the California legislature passed California Code of Civil Procedure Section 580e, which prohibits a mortgage company from collecting on a deficiency if they have agreed to a short-sale. This is true for second mortgages as well if the second lender has also agreed to the sale. This is wonderful news for California homeowners who need to short-sale their homes; however there are some limitations to this law so it is advisable to contact a professional to discuss this option. In addition, people considering a short-sale must also take into account any potential tax liabilities that could arise out of the short-sale scenario.

When you are given a loan, you do not have to treat the money received as income because your obligation to pay it back makes it a liability. However, if the lender decides to forgive or cancel all or part of the loan then the IRS requires that the amount forgiven or canceled be treated as income. This income is taxable and could result in a higher tax liability for the taxpayer. In 2007 Congress passed a law that allowed homeowners to exclude from income the amount of debt a lender forgave or canceled in connection with a short-sale or foreclosure. This law was very much needed as many people, who had already lost everything, including their homes, certainly did not need to face a hefty tax bill as a result of that loss. The clock is ticking on this law however, as it is set to expire December 31, 2013. After that date, people who short-sale or foreclose on their homes again face the burden of owing Uncle Sam for the debt that is forgiven or canceled by their mortgage lender. What people don’t know is that short-sales and foreclosure can take many, many months to complete and if you are just starting to contemplate these options, you may not complete the transaction until after the deadline.

So what should you do? When it comes to excluding forgiven or canceled debt from income for tax purposes there are a number of avenues. One option is to file for bankruptcy. Generally, if the forgiven debt is discharged in a bankruptcy, than it falls into an exception in the IRS code which allows it to be excluded from income. There are intricacies involved so if this is something you are considering it is important to contact a qualified bankruptcy attorney to discuss your situation.

Another way to avoid a tax liability on forgiven or canceled debt is to show the IRS that you were insolvent just prior to the time the debt was forgiven or canceled. You do this by using simple math to add up all the value of your assets and compare that to your total debt. If your debt outweighs the value of your assets you are insolvent and cannot be taxed on the forgiven or canceled debt. Again, it is important to talk to a qualified tax professional to find out if this is an option for you.

Letting go of a home is a huge decision that can affect you both emotionally and financially. It is important to get all the facts and think through all the consequences of foreclosing or short-selling your home.

The Law Offices of Melanie Tavare is a debt relief agency. We help people file for bankruptcy relief under the Bankruptcy Code