“Here is why this is important, aside from Californians being spared from getting hit with a tax bill on a short sale. The Justice Department, in the National Mortgage Settlement, allowed short sales in non-recourse states to count toward the penalty the five biggest mortgage servicers “paid.” If the IRS says something is not a thing of value, it’s not a thing of value. The borrower would not be liable to make up the difference of the mortgage after a short sale anyway in a non-recourse state. The servicer didnt “forgive” anything. So the banks got away with paying off their penalty for a series of crimes with completely worthless non-recourse short sales. That’s the implication of the IRS letter.”
By David Dayen, a lapsed blogger, now a freelance writer based in Los Angeles, CA. Follow him on Twitter @ddayen
The IRS settles something I noticed a while ago and has now been finally confirmed. In short: big banks who robbed homes from Americans got a penalty that entailed, quite literally, giving homeowners worthless allowances.
The issue concerns the Mortgage Forgiveness Debt Relief Act, which expires at the end of the year. After December 31, all mortgage relief that involves debt forgiveness of any kind will be taxable to the borrower. This affects principal reductions, of course, but also short sales, with the idea being that this involves the bank “forgiving” the difference between the total owed on the mortgage and the price of the short sale. There are hardships exemptions to this but they involve the functional equivalent of bankruptcy – you have to prove that your total liabilities exceed your total assets.
Sen. Barbara Boxer wrote the IRS asking for a clarification about short sales in non-recourse states, like her home state of California. If a state is non-recourse, the bank cannot go after a foreclosed borrower post-foreclosure sale for a “deficiency judgment,” seeking money from that borrower if the sale price comes in lower than the price of the mortgage. This also has application for a short sale; technically speaking, in a non-recourse state the short sale is just a waiver of a deficiency judgment. So Boxer wanted to know whether Californians, in a non-recourse state, could still do short sales and not be subject to a tax on the debt relief, even if the Mortgage Forgiveness Debt Relief Act expires. Because, the theory goes, it’s not really a debt relief at all, since the bank cannot go after a California resident for the balance anyway.
The IRS replied to Boxer by affirming her theory:
Homeowners who live in states where mortgages are non-recourse—that is, where they aren’t personally liable for the unpaid balance—may avoid the potential tax hit even if Congress doesn’t act, according to a letter sent by the Internal Revenue Service released by Sen. Barbara Boxer (D., Calif.) on Friday […]
In the letter to Sen. Boxer, the IRS clarified that certain non-recourse debt forgiven by lenders wouldn’t typically be considered taxable income by the IRS. This means that for most California borrowers, the expiration of the tax provision may not have a meaningful effect […]
In the letter, the IRS wrote that “if a property owner cannot be held personally liable for the difference between the loan balance and the sales price, we would consider the obligation a non-recourse obligation.” As a result, the owner would not have to count that forgiven debt as income.