If you owe your lender and cancelled the debt (like in short sale) they have the option to issue you 1099 for the difference of amount.
For example, if you bought your property for $500,000 and now only valued at $350,000 then you are upside down or deficient $150,000! Normally, you will pay income tax for $150,000 cause your lender will probably issue you 1099 (this is an IRS form that will be issued to you at the beginning of the year for the income you made for last year CLICK HERE for more explanation of 1099) for it!
In 2007 (onset of distress property), IRS (Fed) came out with a way out!
The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief. This is valid from 2007 and sunset December 31, 2013.
So remember, some few rules:
1) Primary residence only, meaning you live in the property as your primary residence.
2) Maximum amount allowable is $2M unless filing married but separate is $1M
State (Franchise Tax Board) follow shortly in with their own version of Mortgage Forgiveness Debt Relief valid from 2007 and sunset December 2012. So as you can see…there is a problem in completely being confident doing short sale in 2013! We were seriously waiting for State to catch up so all is good!
Last month, in a letter to California Sen. Barbara Boxer, the Internal Revenue Service (IRS) recognized that the debt written off in a short sale does not constitute recourse debt under California law, and thus does not create so-called “cancellation of debt” income to the underwater home seller for federal income tax purposes. Following the IRS’s clarification, California Association of Realtors sought a similar ruling by the California FTB. Now with the FTB’s clarification, underwater home sellers also are assured that they are not subject to state income tax liability, rescuing tens of thousands of distressed home sellers from California tax liability for debt written off by lenders in short sales.
Distressed California homeowners can now avoid foreclosure or bankruptcy and can opt for a short sale instead, without incurring federal and state tax liability, even after the Mortgage Forgiveness Debt Relief Act of 2007 expires at the end of this year! This assurance is for both Federal (IRS) & State (FTB) level!
If you are upside down and want to avoid foreclosure or bankruptcy…call TEAM BALCH, the Team That Friends Recommend!
Sources: www.car.org, www.irs.gov, www.ftb.ca.gov