After receiving comments from California tax practitioners and its own review of California law, the IRS has issued a clarification to its Sept. 19, 2013, letter to Senator Barbara Boxer concerning short sales and taxes on the forgiven debt. The new IRS letter indicates that forgiven short sale debt is not subject to cancellation of debt income only if it is non-recourse at its inception and that their prior letter was overly broad.
In its new April 29, 2014, letter, the IRS states that in order for a debt to be non-recourse at the time of the short sale, the original debt must be used to purchase or build a 1-4 principal residence or a refinance of such debt. As in the prior letter the IRS affirms that a lender’s forgiveness of such debt in a short sale will not result in COD income, but instead will be treated as capital gains. And as before, single or joint tax filers selling a principal residence can use the appropriate $250,000 or $500,000 capital gains exclusion.
What changed is that a loan used to substantially improve the taxpayer’s principal residence may now be treated as COD income instead of capital gains. Additionally, the IRS clarified that an investor’s short sale debt will also be characterized by the nature of the debt at inception. If it was recourse debt (non principal residence purchase) originally, it will remain recourse debt at the time of the short sale. This may be somewhat good news for investors who may prefer to have short sale debt treated as COD income rather than capital gains. COD income may be avoided under a claim of insolvency where capital gains cannot.
The California Association of Realtors will continue to seek additional clarification about some issues not addressed, such as a taxpayer’s reliance on the IRS’s prior letter, and whether forgiven home improvement debt should not also be excluded from COD income. As always REALTORS® must advise their clients that they cannot give tax advice and that the client should seek tax advice from a qualified tax professional.
Leading the way in California real estate for more than 100 years, the California Association of Realtors® is one of the largest state trade organizations in the United States with 165,000 members. Your local association of realtors, The Lodi Association of Realtors is 92 years old and is one of the oldest and largest associations in our area. We take our duty to the public earnestly and providing you with up-to-date housing information is our privilege.
Eileen Schamber is the president of the Lodi Association of Realtors and can be reached at email@example.com.