Tax Consequences of A Short Sale in California

Tax Consequences of A Short Sale in California

Many homeowners are unaware that when completing a short sale, possible short sale tax issues can arise. As such, an owner considering an California short sale should absolutely discuss these possible issues with an attorney, accountant, or other appropriate professional. From our understanding, the debt forgiven by a lender is generally taxable to the borrower as “debt discharge income.” When a taxpayer receives proceeds from a new loan, those proceeds are not taxable income because there is an offsetting obligation to repay. However, if the debt is cancelled, there may be debt discharge income. This basically means that if you owe $250,000 and short sale the home for $200,000, on your next tax return it could look like you have $50,000 worth of earned income from the sale of your CA residence and would be treated as taxable income. If your lender chooses to, they could send you an IRS Form 1099-C: Cancellation of Debt at the end of the year. This can be a huge financial burden caused by an California short sale…but thanks to “Mortgage Forgiveness Debt Relief Act of 2007″ it no longer is for California homeowners! see below…

BREAKING NEWS! H.R. 1876: The Mortgage Forgiveness Debt Relief Act of 2007 would eliminate the tax owed on any forgiven mortgage debt. This bill has been passed and signed into law by the president! The bill permanently eliminates tax on up to $2 million of debt for a principal residence. This bill protects primary residence homeowners only (not investors), and the best part about this bill is that it is retroactive to January 1st, 2007. This means that any California short sale conducted after that date automatically is protected from any tax implications! It is set to end December 31, 2012. For more info, please visit,,id=179414,00.html


If you are not protected under the new Mortgage Forgiveness Debt Relief Act of 2007, you still have a way around the tax consequences of a short sale. If you receive a 1099-C from a creditor, you must report the amount of the canceled debt as income to the IRS even though you did not actually receive any money (phantom income). (The amount shown in Box 2 of the 1099-C form is the amount that must be reported!) However, the IRS recognizes “Insolvency” as a situation where cancelled debt might not have to be reported as income. Insolvency is basically your total debts exceed your total assets at the time your debt was settled or deemed non-collectable.

If you are “insolvent”, you need to explain this to the IRS in one of two ways. 1) By filling out IRS Form 982: Reduction of Tax Attributes Due to Discharge of Indebtedness ( or 2) Attaching a detailed letter to your tax return explaining the calculation of your total debts and assets.

You accountant can help qualify your insolvency and help you fill out any IRS Forms! Here are some helpful questions that you will need to ask you tax professional:

  • Can I avoid paying taxes on the forgiven debt if I was insolvent at the time of the short sale?
  • Do I have to file bankruptcy to be considered insolvent?
  • If you already went through a short sale and paid taxes can you file an amended return and get a refund?
  • Does a IRS Form 982 have to be filed in order to be eligible for tax relief?
  • Am I protected under the Mortgage Forgiveness Debt Relief Act Of 2007?

Let’s Recap:

The bank accepts an California short sale, your foreclosure is canceled, and you sell your home for less that what you originally owed. The new House Bill H.R. 1876 should protect you, but if you do not qualify, and you receive a 1099-C: Cancellation of Debt at the end of the year, you still have options! Ask your accountant about the IRS Form 982: Reduction of Tax Attributes Due to Discharge of Indebtedness ( If you can prove your insolvency (your expenses outweigh your income) then you should qualify for an exemption and not be taxed on the deficiency.

2 Responses to Tax Consequences of A Short Sale in California

  1. Art Levine says:

    We co signed for our daughter for AZ patio home. The daughter moved on. We are
    doing a short sale. The daughter was the home owner. When we complete the short sales
    the Phantom Income would only apply to those who lived in the house or everyone on title,
    as far as Federal and State taxes are concerned. Who makes the decision on the tax burden.
    My daughter has volunteered to take on the burden alone she could claim insolvency we cannot. What are your thoughts on this situation

    • admin says:

      The persons on the loan would be the ones to get the 1099S for the sale and a 1099G for Gift Taxes for forgiveness of the debt

      However, since your daughter was the one who occupied the home and it was her primary residence then it maybe possible you will not get a 1099G (or have any federal taxes burdens) because the Federal Tax Law currently states as long as it is your primary residence and for her it was – you were the co-signers and as long as you never stated you were going to live there just her then you did everything on the up and up. I would however double check this information with your tax consultant to double check as they know these tax laws inside and out.

      As for state taxes in Arizona I am not sure – In California as of April of last year they were adapting the federal rules.

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