San Diegans who have lost their homes through foreclosure or short-sales thought they had emerged from the dark times and could start rebuilding their lives.
Then the state tax man came calling.
With less than six weeks before taxes are due, an estimated 16,000 former homeowners statewide will owe $15 million in extra income taxes this year and $29 million through 2012.
The tax applies to what is called the “cancellation of debt” that occurs when property owners lose their homes through foreclosure or arrange a short-sale in which they sell for less than the mortgage balance. The lender sends them a form itemizing the forgiven debt, and the amount is subject to income tax.
Congress exempted most homeowners from the extra federal tax through 2012, and the state followed suit for 2007 and 2008 but did not extend the provision last year. The state Assembly may vote tomorrow on a bill to repeal the tax, but Gov. Arnold Schwarzenegger vetoed such a bill last year over unrelated provisions.
“They’re probably stuck,” San Diego tax attorney Bob Kevane said of former homeowners facing the tax. “The biggest way around it is if you’re insolvent.”
Brad Nemeth, another tax attorney, said he doubts the tax will be eliminated.
“The state of California is seriously upside down financially, and I think the governor will probably veto it again,” Nemeth said.
H.D. Palmer, a spokesman for the Department of Finance, said Schwarzenegger remains opposed to the bill in its present form but has not announced whether he will veto it again. Other versions of the tax repeal are in the hopper and could be passed next month, legislators’ analysts said.
Failure to halt the tax could cost Jack and Phyllis Roth of Fletcher Hills as much as $20,000 in state income taxes this year — they paid $781 last year — because of the home they sold short in Flinn Springs in November. They bought it in 2004 for $545,000, invested $50,000 in improvements, and then saw its value fall by one-third before they sold it for $410,000. The result was about $190,000 in net loss that was forgiven by the Roths’ lender.
Phyllis Roth, 63, a tax preparer, said she did not realize until recently that the state would treat the short-sale differently than the Internal Revenue Service would. She estimates her state taxes at $15,000 to $20,000.
“I didn’t call anybody,” she said. “I was looking online and didn’t see anything. That’s what happens when you rely on yourself.”
Jim,
Jim,
I believe the State will also tax foreclosed homeowners as well because they too get the “Cancellation of Debt” from their Note Holder after the home goes through the foreclosure.
I like it. Quit giving breaks to deadbeats.
Well, that is one way to keep people paying on their mortgages…….
Darn right they should pay the tax on the forgiven debt, but I doubt this will change anyone’s behavior – the tax probably amounts to no more than a month or two of the 12 to 24 months of the Free Rent Program.
If they let this slide then it will open the door to all sorts of tax-free transfers of wealth.
Went to an open house in my neighborhood in Carlsbad over the weekend. Was greeted by a nice woman who said she was an agent doing a favor for a friend. Immediately was told it was a short sale and it had termite and mold issues.
I was told, there was an offer from another agent and investment group of $510,000 already on the house.
This is in a neighborhood where homes had typically been going for $650,000 and up. The house is a wreck and needs lots of work. But if it goes for this price or anywhere close it will shake up owners nearby.
Interestingly, the woman who was running the open house said she lived right across the street. After I told he what my rent for a house in the neighborhood was – $1800 – she sighed and said if only her mortgage was anywhere close. She pays about double and it is a NEGAM loan! She should be paying more but can’t afford it plus her house needs a lot of work.
Every month she goes deeper in the hole. She said she’s thought about just walking but doesn’t think she will.
Certainly state taxes don’t help.
“She pays about double and it is a NEGAM loan!”
She is just postponing the inevitable. One way or another, she’ll lose the house. Unfortunately, our government is encouraging that behavior.
-Erica
Does California tax the gains on primary, personal residences?
JP2- Short term cap gains if owned for less than a year. If owner occupied 24 of most recent 60 months, Ca follows FED tax guidelines, first $250K of gain for an individual is excluded ($500K for couple on title) from taxes.
The insolvency exclusion is probably going to get alot of people off the hook for CA taxes on the debt forgiveness.
Justabroker-
So what we have is:
If you live in a place that goes up in value, but less than $250k/$500k, then you’d have the money to pay the taxes, yet you owe no state or federal taxes.
If you live in a place that goes down in value and is sold short, you have to pay the taxes on cash you never had.
This seems a bit backwards. I mean if the government wants to collect tax dollars, shouldn’t that be done from those who are selling at a profit, and not those who don’t have any cash from the sale?
As long as property values always go up, life is good, I suppose.
[i]The insolvency exclusion is probably going to get alot of people off the hook for CA taxes on the debt forgiveness.
dacounselor | March 8th, 2010 at 11:39 am[/i]
You would think so, but not for walkaway people like these. I seem to remember (but am not certain) that the insolvency tests *include* any retirement savings and pensions.
So the subprime FC or SS can claim it, but the “discretionary” walkaway will have to pay up.
(and Yay, says me)
The ruthless defaulter with ample assets and the means to pay isn’t likely to pencil out as insolvent. Worst case scenario for them even if they have to pay debt-cancellation tax? At worst a wash but probably still a net plus considering many months of no mortgage payments and property tax payments. Or they buy and bail and then rent the property out until foreclosure.
Still we’re probably talking about a relatively small % of defaults. I think a pretty good chunk of those 16,000 former homeowners will pencil out insolvent, expecially considering recourse heloc debt is not restricted in the insolvency calculation by the fmv of the property. Add in their credit card debt. And if they are the typical Great American Consumer they don’t have alot of assets on the plus side. Hello insolvency, goodbye tax.
I know California has its fair share of tax revenue problems.
My new tax platform: Only tax the insolvent!
I’d run for governor, but I’m not a (porn) star.
The cancellation is taxable.. but the asset value loss is deductible (on a net basis). Payments on mortgage interest are also deductible. If we completely forgave the loan loss forgiveness, someone could easily live with nearly everything tax deductible if they are willing to go through the foreclosure nightmare.
NOTE: The federal tax is exempting loan loss forgiveness as taxable income, so only state has to be worried about.
Can we re-institute debtors’ prisons?
“The cancellation is taxable.. but the asset value loss is deductible (on a net basis).”
So the debt forgiveness is only taxable if there was a refinance, since the basis of the asset was not reset?
JP2, If someone owes $500k and short-sells for $450k, they’re getting a $50k gift from the bank. Of course it should be taxed. This is still better for the deadbeat than to have to come up with the $50k like he should.
I bought my first home in 2005. In 2008 is was told I either had to move to Chicago or lose my job. At that time the value of my home was 150,000 less than the purchase price. Had to do a shortsale. Not everyone is a deadbeat.
“JP2, If someone owes $500k and short-sells for $450k, they’re getting a $50k gift from the bank. Of course it should be taxed. This is still better for the deadbeat than to have to come up with the $50k like he should.”
If that person purchased the home for $500k (100% financing), then they have a $50k loss and a $50k gain. Don’t these cancel each other out?
“If that person purchased the home for $500k (100% financing), then they have a $50k loss and a $50k gain. Don’t these cancel each other out?”
Good question – I guess it depends whether they’re taxed as gains or income. I’m guessing the gift from the bank is taxed as income and the write down can go either way depending on ow long they’ve owned it. I’m sure someone out there knows, and will hopefully share with us. But even if they cancel each other out, at least they’re not getting a tax benefit for short-selling.
The “deadbeat” comment was harsh, so I take it back. But I still hold that a short seller is not living up to the financial agreement and receiving a gift from the bank.
Now back to my original thought:
If a person refinances, and uses the cash to buy non-capital goods, then the tax basis is not increased.
Thus, back to #17, “So the debt forgiveness is only taxable if there was a refinance, since the basis of the asset was not reset?”
There is nothing to offset a refinance, if I am thinking about this correctly.
I guess this gets to book value too. Individuals carry the home at purchase price, generally speaking (there may be some additions, but there is no depreciation).
Now that I think about it, I bet there are a lot of former “homeowners” who wish they kept receipts for all those upgrades. You know, the SS sink, SS appliances, and so on. While I am sure the appliances didn’t stay with the home, I bet the paperwork would suggest otherwise…
In any event, maybe that could be added to the tax basis, and then any potential gain on forgiven debt could be minimized. I am no tax professional. I am not an attorney.
Of course, if the Home ATM cash was used to buy computers, automobiles, and so on, then these purchases cannot be added to the tax basis of the home.
In the case of the Home ATM, the cash from the forgiven debt was actually in the hands of the person being taxed. In the case of buying a home for $500k and selling it later for $450k (100% financing; interest only), the “homeowner” taxpayer never saw $50k in cash.
I find it very interesting that many people purchased suggesting what a great deal it was come tax time.
Now that I think about it, I bet there are a lot of former “homeowners” who wish they kept receipts for all those upgrades.
I certainly think that’s something to talk to a tax professional about. Does money you spend on your home increase the tax basis of said home when you go to sell it? I have troubles believing that it does, since otherwise a flipper wouldn’t have to pay taxes on the increase in value of the house.
“Does money you spend on your home increase the tax basis of said home when you go to sell it?”
Capital improvements certainly do.
Flipper example:
Buy home for $100k
invest another $100k
Total invested: $200k
Sell home for $300k
Total taxable gain $100k
It should be noted, however, that most homeowners that occupy the homes are not taxed, within certain limits.
But if you are a homeowner, and you buy land for $100k and build a structure on it, certainly the basis is the cost of the land PLUS the cost of the structure.
Similarly, if you buy a home for $500k and improve it with another $50k, then your tax basis is $550k.
That said, if you buy a home for $500k and later borrow $550k because the value went up (the classic Home ATM), then without additional information the tax basis is still $500k. We need to know what happened to the other $50k.
There appears to be some confusion in the comments as to how taxation of cancellation of indebtedness works. I am not an accountant, and it can get complicated, but I think here are some general rules:
If the debt is non-recourse (which in California means purchase money owner occupied 1-4 units or seller carryback financing), then there is no cancellation of indebtedness income under Federal or California law.
If the debt constitutes “Qualified principal residence indebtedness” under the Mortgage Forgiveness Debt Relief Act of 2007, (meaning rate and term refinances without cash out, or cash out refinances for purposes of improving the residence), then cancellation of indebtedness is not taxable under Federal law up to $2 million , but may be taxable under California law.
ATM style consumption cash out refinances or investment properties debt will be subject to taxable cancellation of debt unless you can meet the insolvency exception.
An area of potential creativity around these rules is if you can raise legal issues for violation of truth in lending or other law and reach a settlement agreement with the lender to “rescind” the original loan so there is no debt to cancel and the lender agrees not to issue a 1099.
Er, yes they did. They received $500K in cash from the bank, which they immediately spent to buy the house. Then the market value of the house fluctuated. They then returned $450K to the bank after the short sale. It doesn’t change the fact that the homeowner had and made use of the “extra” $50K on which they’re now being taxed. (Some fraction of that should be offset with the capital loss on the house, but that’s Tax Attorney country…)
On the flip side, consider colluding actors trying to avoid inheritance or gift taxes. Mommy and daddy “loan” their son Derek Silverspoon a million dollars to buy a house. Derek then “defaults” on the loan. Mommy and daddy cry crocodile tears, and write off the million as a, “capital loss.” Derek ends up with $1.0E+06 of value tax-free. Filing the loan forgiveness 1099 against Derek addresses this scenario.
Appears that the article focuses on a tax preparer who was not aware of the state tax on short sales. I’m not sure she’s doing herself any favors by publically disclosing her incompetence and inability to do the necessary research. Good grief…
“They received $500K in cash from the bank, which they immediately spent to buy the house. Then the market value of the house fluctuated. They then returned $450K to the bank after the short sale.”
But they also had a $50k loss on the sale of the asset, so once again, we are back to zero!
“On the flip side, consider colluding actors trying to avoid inheritance or gift taxes. Mommy and daddy “loan” their son Derek Silverspoon a million dollars to buy a house. Derek then “defaults” on the loan. Mommy and daddy cry crocodile tears, and write off the million as a, “capital loss.” Derek ends up with $1.0E+06 of value tax-free. Filing the loan forgiveness 1099 against Derek addresses this scenario.”
If Derek has the home, then yes, he now has a $1M home with the debt forgiven. If, on the other hand, the place sells for $100k at auction, then Derek has a $900k loss on the home with a $900k gain on the canceled debt.
What about the scenario where you used a purchase money loan, non-recourse state (Cali), primary residence, never refinanced and had to move due to job transfer? Is that owner subject to Cali state tax if tey short sold? This article seems to focus on a couple who sold their secondary home and not the primary. They also pulled out cash.
The irony in this is perfect. Speculators, ATM deadbeats, and cash out refis are the ones getting hit, as opposed to the purchase money non-recourse buyers.
And stop trying to compare people who sold the house for a profit and deadbeats who intentionally avoid paying their debts. This is like comparing business owners to bank robbers.
But they also had a $50k loss on the sale of the asset, so once again, we are back to zero!
The homeowner didn’t take the loss-the bank did. Now, if the homeowner did a normal sale, paid off the loan in full, and came up with fifty grand in cash at closing, then they would have the loss and could deduct it. But if they do a short sale, they have a fifty grand paper gain-they owed the bank five hundred grand, but only paid it $450k.
Geotpf,
If you buy a home for $500k and sell it at $450k, you have a $50k loss, no matter how it’s financed.
Similarly, if you buy a home for $450k and sell it for $500k, you have a $50k gain, and once again, it does not matter how it’s financed.
If you borrow $500k and $50k is forgiven, you have $50k in income.
Now if you buy a $500k home (100% financing, interest only) and short sell it for $450k, then:
1. You lost $50k on the sale of the home.
2. You gained $50k on the debt forgiven.
I should note that I am not making any claims about how any of the losses/gains are taxed. That’s why you hire a tax professional.
The federal government and many states are not taxing owner occupied short sellers and foreclosure sellers based on a debt forgiveness 1099 received from the bank, the so called phantom income they never actually recieved. California should do the same but probably won’t because of the budget mess in Sacramento. Many of these folks don’t deserve the insult after injury in an economic collapse largely caused by poorly regulated Wall Street bankers and banks, who came up with phony mortgage securities and credit default swaps, created a financing bubble which largely lead to a housing bubble, and then made millions by selling them around the world. Then they (Wall Street and the Banks) got bailed out with billions from you and I, the tax payers of America. So who really got the gift? The seller who lost his job and home and the bank is gave them a gift in the form of a $50,000 taxable 1099? Or Wall Street and the banks that recieved billons in a bail out funded by you and I for a situation they created. It’s a sad state of affairs. Let these people move on with their lives.
I disagree. Here’s how things work:
1. You have zero dollars.
2. You then have $500k cash and a $500k debt.
3. You then have a house worth $500k and a $500k debt. To make things simple, assume zero down and interest only payments, so no equity accures.
4. Then the house is sold for $450k. You now have $450k cash and a $500k debt.
5. The bank “gives” you $50k, takes the $450k, and cancels the $500k debt.
Net taxable profit should be $50k, although you never see this money in the real world-it basically went to the new buyer of the house.
Geotpf,
I know you want to ignore this, but:
6. There is a $50k loss on the sale of the home.
“Net taxable profit should be $50k, although you never see this money in the real world-it basically went to the new buyer of the house.”
NO! The buyer purchased a $450k home.
This reminds me of going to the store near Christmas, and there was a rack of junk 90% off. I purchased a $10 item ($100 original price), and the cashier suggested I “saved $90” by buying a $10 item.
The thinking is that the bank gave you the 50k in forgiveness, since you owed 500. Without the short sale you would have had to come to closing with a 50k check to close. Effectively the bank gave you that check with the short sale so it is definitely income. At the end of the deal you are 50k better off than if you paid off the house at closing. Now if you file for bankruptcy a whole different story arrives, just like bankruptcy cancels recourse everywhere. Note that if you used the home atm my understanding is the CA mortgage is recourse. Sooner or later the banks will sell the recourse debts to the bill collectors for a few cents on the dollar and the bill collectors will come get the borrower.
Is it any wonder why I suggest hiring a financial professional to help people make financial decisions?
Let’s take the example of $0 down, interest only, $500k purchase/loan.
Using A=L+E
Step 1: Borrow $500k
A-Cash = $500k
L-Debt = $500k
E=$0
Step 2: Buy home
A-Cash = $0
A-Home = $500k
L-Debt = $500k
E=$0
Step 3: let some time pass.
A-Cash = $0
A-Home = $500k (book value)
Home = $500k + $x (market value)
L-Debt = $500k
(x might be negative, positive, or zero)
Step 4: Sell home short (x negative, less than zero)
Right before sale:
A-Cash = $0
A-Home = $500k (book value)
Home = $500k + (-$50k) = $450k (market value)
L-Debt = $500k
E=$0
Right after sale:
A-Cash = $450k
L-Debt = $500k
E= -$50k (negative)
From the sale:
Home = $500k (book value)
Home = $450k (Sale price)
Capital loss on Sale = $50k
The lender quickly gets paid:
A-Cash = $0k
L-Debt = $50k
Loss on sale of home = $50k
If the debt is forgiven, then there is a gain of $50k.
Please note that if the home’s market value did not go down, then there would not be any loss to any party.
Those who are selling their houses at a loss are already hurting by diminishing values and probably loss of jobs also. State must help them instead of taxing them