New Federal and California Developments on Cancellation of Indebtedness from Short Sales

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On September 19, 2013, the IRS issued a Chief Council Letter where it stated that the short sale of a California principal residence converts the mortgage to a nonrecourse loan and is treated as a sale, not Cancellation of Indebtedness.  Under California law, when agreeing to a short sale, the bank may not go after the borrower for any shortfall on the debt.  The letter stated that, under the anti-deficiency provision of Code of Civ. Proc. §580e, the debt would be a nonrecourse obligation, and for federal income tax purposes the homeowner will not have COD income. Instead, the full amount of the nonrecourse indebtedness is treated as the sales price.

The California Franchise Tax Board has just updated their website to include information about mortgage debt relief for taxpayers who sold their principal residences through a short sale in 2013.  The FTB guidance confirms that California will follow this treatment.  The FTB clearly states that the IRS guidance is limited to California short sales only, and that the IRS guidance did not specifically address other types of real estate transactions, such as non-judicial foreclosures and mortgage loan modifications.

The information posted by the FTB can be found here.

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