New law drops state tax on forgiven debt

Distressed homeowners no longer have to pay California state income tax on debt forgiven in a short sale, foreclosure or loan modification, the California Association of Realtors® reports.

Senate Bill 401 generally aligns California’s tax treatment of mortgage debt relief income with federal law, according to the association. For debt forgiven on a loan secured by a “qualified principal residence,” borrowers are exempt from federal and state income tax consequences. The federal exemption is for indebtedness up to $2 million; the new California exemption is for indebtedness up to $800,000 and forgiven debt up to $500,000.

“Qualified principal residence” indebtedness is debt incurred in acquiring, constructing or substantially improving a principal residence. It includes first and second trust deeds. It also includes a refinance loan to the extent the funds were used to pay off a previous loan that would have qualified.

The tax breaks apply to debts discharged from 2009 through 2012, the association reports. Californians who filed their 2009 tax returns may claim the exemption by filing a Form 540X amendment.

Taxpayers who have a second home or rental property and do not qualify for the exemptions may be exempt under other provisions. For example, taxpayers who are bankrupt are exempt from debt relief income tax, and those who are insolvent are exempt from debt relief income tax to the extent their current liabilities exceed current assets.

For more information about mortgage forgiveness tax consequences, go to California Franchise Tax Board’s Mortgage Forgiveness Debt Relief Extended webpage and the Internal Revenue Service’s Mortgage Forgiveness Debt Relief Act and Debt Cancellation webpage.

The full text of Senate Bill 401 is available at www.leginfo.ca.gov.