Home Seller

IRS reverses opinion on ‘debt forgiveness tax’

By From page HSR3 | June 14, 2014

Throughout the more-years-than-I-want-to-count history of this column, I have very occasionally broken from the question-and-answer format to pass on some breaking news that I think is relevant to the readers.

This is one of those columns.

The housing mess we’ve gone through from early 2007 until just recently, and perhaps currently depending upon your perspective, has taught us all a lot of things.

Among them is, “Yes Fred, you can lose money in California real estate.” Not to mention, “No, son, owning your own home is not everyone’s idea of the American dream.”

All of us, myself included, got seriously schooled on liability issues to mortgage holders, foreclosure procedures, and the fact that meaningful loan modifications are mostly a fairy tale.

However, there is one serious issue for millions of Americans, and most particularly Californians, that has been left unresolved. That would be taxes.

There are two types of taxes that could be leveled at anyone who no longer owns real estate, regardless of how they came to not own it anymore. Foreclosure, short sale, “regular sale,” etc., it doesn’t matter.

The first is capital gains tax.

No real mystery there. Theoretically it’s a tax on the profit you made from your investment. A relatively low tax, but a tax nonetheless. Those as cynical as I will tell you it was devised so rich people could pay taxes at the poor peoples’ tax rate. But that’s for someone else’s column.

However, the tax is what it is and your accountant can tell you if you owe any.

The other type is something most consumers have never had to deal with. Often called debt forgiveness tax, the proper name is cancellation of debt income tax. It goes like this:

If I’m a commercial lender and I lend you $10, and later “forgive” that 10 buck obligation, I have to send you a 1099 and you add it to whatever 1099s and W2s you have and pay income tax on the total.

The tax has been around forever, but mostly affected businesses who restructured their business loans. Consumers seldom had to deal with it, at least not in large figures.

Perhaps it makes sense.

In my $10 example, you got 10 bucks. It may not have been salary, but you got it so perhaps you should pay income tax.

Fast forward to 2007. The housing market has tipped across the country. Home values are going down fast. To make it worse, huge numbers of homebuyers in 2004 and 2005 bought their homes with no money down, meaning they had zero equity the day they moved in. Then the value dropped.

As the economy faltered, people began to have their incomes cut, or eliminated altogether. Additionally, many of the crazy loans out there became due and payable. Homeowners had negative equity and couldn’t refinance. Foreclosures started across the country and only accelerated over the next five years.

So, in a nutshell, banks would foreclose on a house, lose hundreds of thousands of dollars they would write off, and then send the ex-homeowner a 1099.

The result was that the borrower would have to add those hundreds of thousands of dollars they never saw to their income and pay taxes on it. Not only that, but the added phantom money took their tax bracket right up to the top, so they paid more taxes on the money they had earned as well.

In response, President George W. Bush signed a temporary amnesty for those who lost their primary residence. That was renewed for a few years but expired long ago.

So now we come to California.

There has long been an exception to this tax for California homebuyers who bought a property that they intended to live in. The exception, known as the “purchase money” exception, only applies to the original loan(s) that was used to purchase the property.

In the event of a default, the homeowner is never personally liable to the bank, which means the bank lacks the capacity to sue to collect, which means they can’t “forgive,” which means it’s not taxable.

You lose that protection if you refinance or acquire a second mortgage after you own the property.

In 2011, a law went into effect that appeared to accomplish the same thing for any mortgages that were on a home when it was short sold.

California Code of Civil Procedure Section 580(e) says in effect that if a bank agrees to a short sale, the loan becomes nonrecourse, meaning the bank can’t sue.

Remember this is a state law, so we were left guessing how the IRS would look at it.

Due to the uncertainly, U.S. Sen. Nancy Pelosi sent a letter to the IRS asking how they were going to treat the written-off debt from a California short sale.

We all cheered when the IRS returned an opinion letter last fall expressly stating that a short sale in California was not subject to debt forgiveness tax. We cheered right up until two weeks ago.

The IRS sent a second letter late last month to “explain” the first letter, effectively reversing everything the first letter said. Specifically, that regardless of Section 580(e), it was considered canceled or forgiven debt and was therefore taxable unless it was purchase money.

Now, the law says nobody is supposed to rely on IRS opinion letters, which makes this attorney wonder why they issue them in the first place.

So the answer to the question, “Do I have to pay debt forgiveness tax on my nonpurchase money loan if I short sold in the last couple of years?” is totally up in the air. As you can imagine, the answer will affect millions of people.

Write your congressman, senator, city councilman, clergyman, town dog catcher, whoever, and raise a stink. No tax regulation with the ability to do so much damage to those who have already suffered should have to be interpreted by a flip of the coin.

Tim Jones is a real estate attorney in Fairfield. If you have a real estate questions you would like to have answered in this column you can contact him at [email protected].

Tim Jones


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