California Aligns with IRS Regarding Income Tax on Cancellation of Debt Income

I am often asked “What is Cancellation of Debt income?”

If a person sells their home and the proceeds of the sale do not result in the ability to pay back the mortgages in full, the lender may agree to accept a “short” payoff. When this occurs, the lender must write off the amount that is not paid back (cancelled debt). This can also occur in a foreclosure. Since this is money that was loaned to an individual and not paid back, tax authorities view it as income to the individual. The lender issues a 1099C in the amount of debt cancelled to the borrower that did not pay back the loan in full. The income on this document must be reported on the borrower’s tax return.

Since the federal government enacted the Mortgage Forgiveness Debt Relief Act of 2007, an individual that experiences a foreclosure or short sale of their primary residence is allowed to exclude the amount of debt cancelled from their income for tax purposes. This special federal program remains in effect until December 31st 2012. Second homes and investment properties do not qualify.

When the federal program was enacted California followed the federal guidance and put in place a similar program regarding state income tax due on COD income. That program sunset at the end of 2008. When the program ended it exposed individuals who have COD income as a result of short sale or foreclosure to a 9.3% tax due to the Franchise Tax Board in California.

Fortunately, on April 12, 2010, the Governor of California signed Senate Bill 401 into law. This bill realigns California with the federal government regarding income tax due on COD income. The bill will protect borrowers that experienced a short sale or foreclosure resulting in COD income during 2009 through December 31st 2012. The qualifying guidelines remain consistent with the federal program. The property that resulted in the COD income must be a primary residence, no second homes or investment properties qualify.

Details on the federal program
Details on the state program

It is critically important that you consult a Tax Professional when evaluating your specific situation regarding COD income and how it may affect your tax status.