On very rare occasions, a breaking news story occurs in the real estate world that I think is important enough that I dispense with the usual question-and-answer format. This is one such occasion.
So as the emails continue to pile up I’ll offer my apology now to everyone who submitted questions this week and we’ll return to the traditional format next week.
It’s no secret to anyone that for the past six years we’ve been in the throes of the worst economic situation most of us have ever faced. For people interested enough in real estate to read this column every week, they’ve noticed that the Great Recession actually started a couple of years earlier than that in the California real estate market.
Since early 2007, I estimate I’ve sat down with more than 6,000 couples and individuals who were looking at the specter of losing their homes. Most of them did.
That’s 6,000 people who found their way into my office. For each one of them, there were hundreds who didn’t.
At those meetings we went over the homeowners’ particular problem, their property, their loans, often their current finances, with the purpose of looking at the law and determining a course of action.
Today’s column is about new certainty in what was a gray area in the law as it affects a homeowner’s tax liability. Changes in state law ran up against court decisions and federal tax law to create a situation in which nobody could be sure they had the right answer.
That is, until now.
But first, a little history.
As we go through this otherwise dry subject matter, remember there are two major types of liabilities when you lose a home. It may be possible for the bank to sue you for the money they lost, and it’s possible you would have to pay taxes on the money they didn’t sue you over.
Remember the name, Cancellation of Debt Income Tax, or CDIT for short.
CDIT has been around for a generation. It’s nothing new and has primarily been something businesses had to deal with when restructuring loans.
In short, when a commercial lender forgives all or a portion of a loan, the borrower has to pay income tax on the amount the lender forgave.
There are certain exceptions in California, but for most California homeowners the thinking was if the bank forecloses, allows a short sale or reduces the loan balance in a modification, the homeowner is going to have to pay a pretty heavy tax bill.
For example, a homeowner who owes the bank $300,000 and short sells the house for $160,000 would cause the bank to lose $140,000. So not only did the homeowner lose their house, they now have to add $140,000 to their income when calculating their taxes. That would automatically push them up to the highest tax bracket and there could be a bill for $50,000 or more.
A temporary reprieve was signed into law in 2008, essentially forgiving the federal tax on people who lost their primary residence, although that forgiveness had a number of exceptions.
The protection is scheduled to expire Dec. 31.
Here in California, a new law went into effect Jan. 1, 2011, and further improved in July of that year, which essentially says if a lender allows you to short sell your home, the bank can’t then sue you for the money it lost. In other words, the state changed the law that turned short sold loans into nonrecourse loans. That is, the bank has no legal recourse.
But nobody knew for sure how the IRS would treat this. At first the advice was that since the loan was now a nonrecourse loan, the bank could not forgive something it wasn’t owed and there would be no tax.
Then a court decision turned that on its head, saying the bank didn’t have to allow the short sale but chose to and so it was de facto a forgiveness of debt and was taxable. So, two years ago or so, lawyers and CPAs reversed course and treated the money the bank lost as taxable.
In November, at the urging of Sen. Barbara Boxer, the IRS issued a letter stating that since the loan has become nonrecourse in nature under California law, the IRS does not consider it taxable income after all.
Shortly after the IRS letter, the California Franchise Tax Board issued a similar letter.
So the advice we gave during the first two years or so turned out to be correct.
What this means is if you are one of the millions who lost a property, even if you didn’t live in it, after Jan. 1, 2011, you need to go see your tax adviser.
It’s very possible that if you paid CDIT you may be able to file an amended return and get your money back.
However, before you start thinking about how you’ll spend the money, as with everything “tax” there are nuances, exceptions and complexities far too vast for this column. So your tax adviser will have to look at the totality of your tax situation.
But still, I have to believe that this new IRS guidance is going to give relief to tens, if not hundreds of thousands of taxpayers.
Tim Jones is a real estate attorney in Fairfield. If you have any real estate questions contact him at SolanoScene@TJones-Law.com.