Short Selling your Los Angeles Home – Will I Have to Pay Taxes on Debt Forgiveness?

What is a short sale?

If you are having a hard time paying your mortgage and owe more than the property is worth, then you may consider short selling your Los Angeles home.  What this means is that you would list the house at market price and work with prospective buyers until your come to an agreement.  Your listing agent would then approach the lender and work with them on an acceptance of the buyer’s offer.

This is a long and involved process during which you would have to prove hardship, and there is no guarantee the lender will agree to the sale, even though the alternative could be foreclosure.

Will there be a deficiency judgement on my Los Angeles short sale?

As of January 1, 2011 Civil Code section 580e was introduced which states that on residential one to four-unit buildings the first trust holder cannot get a deficiency judgement against the borrower, even if there was no specific waiving of their right to do so, which was previously required.  However it would be a good idea to have the first trust deed holder specifically waive the right to pursue deficiency judgement.

However a second trust deed holder can pursue a judgement if they don’t specifically waive it, even if they have approved the short sale.  If the property is sold, the second trust deed holder would have to sue the seller to obtain the deficiency judgement in order to place liens on any of the seller’s properties or garnish the seller’s wages.

Will the forgiven amount be taxed?

When short selling your Los Angeles home,  the IRS or Franchise Tax Board could consider the amount forgiven by the lender as income for the seller, and this would be taxed at ordinary income rate, which would be a severe blow to the seller.  But luckily, this is unlikely to happen due to the insolvency provision of tax laws, and Federal and California laws that were passed offering tax relief for cancellation of debt income in short sales.

The federal Mortgage Debt Relief Act of 2007 offers such provisions as:  if the home is the seller’s principal residence and a mortgage was taken out on the property to acquire, build, or improve it, then the forgiven debt will not be taxed.  Refinancing of the property will also not be taxed.  However, if cash was taken out over and above the original mortgage and was used for anything other than improvements to the property, then that amount will not be tax exempt.  So don’t go out and buy a car.  There is a cap on the cancellation of debt income:  $2M, or $1M if you are married and filing separately. California exemption is $500,000 or $250,000 respectively.

Be aware that these laws are due to expire at the end of 2012

What if I am not eligible for tax relief?

If you are short selling your Los Angeles home  and find that you are not eligible or only partly eligible for tax relief, you may be able to get relief by being insolvent under the tax laws.  If your liabilities are greater than your assets at the time of the Los Angeles short sale the tax laws would designate you as “insolvent”.  Depending on those liabilities the seller’s tax indebtedness could be greatly reduced or eliminated.

The benefit of the insolvency provision of the tax code is that the above restrictions – primary residence, residential income, money taken out and applied to the home only – do not apply.  To see if you qualify for the insolvency provision you should consult a tax professional.

Will I get a 1099 for the cancelled debt?

A short seller will most certainly receive a 1099 for the cancelled debt.  Even though it may not be taxed it does have to be reported.

If you are thinking of short selling your Los Angeles home,  you must use a listing agent familiar with the ins and outs of negotiating one of these difficult transactions.  While I am not a short sale agent, I have worked with experts in the field and will be happy to refer you to one.

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2 thoughts on “Short Selling your Los Angeles Home – Will I Have to Pay Taxes on Debt Forgiveness?”

  1. Hi Jane. The good news is that in addition to all of the items you mention here, we now also have SB 458 in California which even protects short sale sellers from deficiencies in the junior position.

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