In California, homeowners who sell their home through a short sale may qualify for the California Mortgage Forgiveness Debt Relief under SB 401, which was enacted on April 12, 2010. This mortgage forgiveness debt relief act allows taxpayers who have had all or part of their loan balance on their principal residence forgiven by their lender to exclude the forgiven debt from California gross income. This tax relief for those who short sell their homes in California apply to discharges of qualified residence indebtedness on or after January 1, 2009 and before January 1, 2013. Read more about this from the California Franchise Tax Board website under SB 401.

The California Tax Relief limits the amount of qualified principal indebtedness up to $800,000 for those who file as married, joint, head of household and up to $400,000 for those who file as married/RDP filing separately. See State of California Franchise Tax Board for more details. In order to claim tax relief, your would need to file Form 540 or Form 540X for a previously filed tax return.

Consult your tax advisor regarding how this tax relief may apply to your individual situation.

Currently there is a disparity between the Federal and State of California Mortgage Debt Relief Forgiveness Tax Treatment for 2013

2013 Update on State of California Short Sale Mortgage Debt Relief Forgiveness:

SB-30 Taxation: Cancellation of Indebtedness: Mortgage Debt Forgiveness in California.This bill would extend the operation of the exclusion of the discharge of qualified principal residence indebtedness to debt that is discharged on or after January 1, 2013, and before January 1, 2014.

As of this writing SB 30 is an active bill in committee process. Lawmakers are in favor of extending the California cancellation of indebtedness: mortgage debt forgiveness. The bad news is that SB 30 is being held hostage to an unpopular bill SB 391, which makes SB 30 operative only if Senate Bill 391 of the 2013–14 Regular Session is enacted and takes effect!

The federal Mortgage Forgiveness Debt Relief Act only provides for the exclusion of COD income relating to qualified principal residence. If you have COD income as the result of a foreclosure on other property, such as a second (vacation) home, rental, or other business property, you may still be able to exclude COD income under other provisions if:

1. You were bankrupt when the discharge occurred (Title 11 discharge).
2. You were insolvent (limited to level of insolvency).
3. Qualified farm indebtedness was canceled.
4. Debt was Qualified Real Property Business Indebtedness (QRPBI)³ and you make a federal election.

The Mortgage Forgiveness Debt Relief Act of 2007  applies to original or refinanced loans that were used to acquire, build, or improve upon on your primary home.

If the loans forgiven were loans that you used to purchase the home (purchase money loan) or loans used to build or improve the home, most likely you would not have to pay taxes if you complete a short sale before December 31, 2013.  Note that a portion or all of the forgiven amount would be considered taxable income if the forgiven amount, or if portions of the loans forgiven were used for other purposes- i.e. cash out refinance used to payoff i.e. car loans, credit card debt, etc.

Click here to read more information on the Mortgage Forgiveness Debt Relief Act of 2007

Is Cancellation of Debt income always taxable?
Not always. There are some exceptions according to the IRS. The most common situations when cancellation of debt income is not taxable involve:

• Qualified principal residence indebtedness: This is the exception created by the Mortgage Debt Relief Act of 2007 and applies to most homeowners.
• Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
• Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your total assets.- How do you know if you are insolvent?
  According to the IRS, “you are insolvent when your total debts exceed the total fair market value of all of your assets.  Assets include everything you own, e.g., your car, house, condominium, furniture, life insurance policies, stocks, other investments, or your pension and other retirement accounts.”
• Certain farm debts
• Non-recourse loans

Consult your tax advisor regarding how this short sale tax relief may apply to your individual situation