Relief if You Paid Tax on a Short-Sale 2011-2013

Originally published in the Cedar Street Times

February 21, 2014

Hopefully we are nearing the end of the short-sale and foreclosure saga that has continued since 2008.  My litmus test based on tax return filings is indicating that things are much closer to being back on track.  Prior to 2008, it was all about 1031 exchanges.  Those turned off like a faucet when the markets crashed, and then short-sales and foreclosures took center stage.  I have seen those tapering off over the last couple years, and I am starting to see 1031 exchanges again.  The cycles continue!

But before we leave short-sales and foreclosures in the dust, there is a possible silver-lining handed down by the IRS and FTB in the last few months.  Taxpayers that generated income tax as a result of a short-sale in California on their principal residence, retroactive to January 1, 2011, may be entitled to a refund.

California Code of Civil Procedure Section 580b has been dubbed California’s “anti-deficiency laws” for years.  It had a positive effect on homeowners because it basically said if you had never refinanced your home and you lost it in a short-sale or foreclosure that you could not be pursued for the balance you still owed (the deficiency), and the remaining debt would not be taxable income to you because the debt was considered nonrecourse debt.

This, however, left many people out in the cold that had refinanced.  Suddenly, it was a different ball game if you had done a refinance (and who didn’t during the run of good years up through 2007!?), and the debts were then allowed by lenders to be treated as recourse debts and they could pursue your personal assets.  Alternatively they could cancel the debt if it was not worth pursuing, leaving you with taxable income for the amount cancelled.

Congress stepped in (and California generally conformed) during the housing crisis and enacted favorable legislation which said you could exclude cancellation of debt income generated by your personal residence.  The catch, however, was that the debt had to be “qualified debt.”  In short, if you lived off the equity in your house by refinancing to pull cash out and did anything with it other than improve the property, then you were not eligible for the exclusion on that portion and would still have to pay tax.

Then, a few years ago, California passed Senate bills 931 and 458 which were codified into law as California Code of Civil Procedure Section 580e as of January 1, 2011.  This resulted because some unscrupulous lenders were entering into short-sale agreements to allow sellers to go through with the sale of their property for less than the amount owed to the bank, but then still pursuing the seller for the remaining debt after the fact (often a big surprise to the seller).  California’s enactment of this law was good news for homeowners because it basically said, even if you had refinanced, but had entered into a short-sale agreement with a lender, then you could not be pursued for the remaining balance owed and that lenders would basically have to cancel the debt.  Of course, cancelling the debt could mean tax was owed, but that was still better than being pursued for the remaining balance!

Finally, in November 2013 a letter from the Office of the Chief Counsel at the IRS written to Senator Barbara Boxer, due to an inquiry from her, stated that the IRS would treat any debt pursuant to California’s 580e as nonrecourse debt!  The Chief Counsel’s office at California’s Franchise Tax Board followed up with their own letter a month later saying they will conform to the IRS interpretation.

This means that anyone who filed a tax return in 2011 or 2012, or even this year, and reported cancellation of debt income related to the short sale of a principal residence, should consider filing an amendment for a possible refund.  It is still possible to have income tax, primarily if you did not live in the house for two of the last five years prior to your short-sale.  The reason is that when a home is disposed of with nonrecourse debt, the total amount of debt outstanding at the time of the short-sale becomes the sales price of the home.  You then subtract your cost basis, and the difference is your gain on sale.  However, if you lived in the home for two of the last five years, then you get a $250,000 gain exclusion for filing as a single status, and $500,000 gain exclusion if married filing jointly, pursuant to IRC Section 121.

You need to act on this during the next year if your short sale was in 2011 as the statute of limitations expires three years after filing.

Prior articles are republished on my website at www.tlongcpa.com/blog.

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

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