No COD Income on California Short Sales!

Cancellation of debt (COD) income has been a surprise to many people who lost their homes in a foreclosure or a have had a short sale.  COD income occurs when there is a recourse loan on a property, the property is foreclosed upon and the lender relieves the debtor of any balance due on the loan.  Even though the debtor does not receive any cash, they may have COD income.  It is critical to understand the difference between recourse and non-recourse debt.

Recourse versus Nonrecourse.  A debt for which the borrower is personally liable is recourse debt.  All other debt is nonrecourse.  Tax treatment of the two types of debt is dramatically different.

For recourse debt, COD income is calculated as the difference between the amount of the loan discharged and the fair market value of the property.  A second calculation is made to determine any gain or loss on the disposition.  The difference between the fair market value and the seller’s adjusted basis (usually cost) will result in a gain or loss on the disposition.  The character of the gain or loss is the same as the character of the property.

For nonrecourse loans there is no cancellation of debt income.  A single calculation is made.  The difference between the loan balance and the seller’s adjusted basis will result in a gain or loss on the disposition.

In California a purchase money mortgage (the original loan used to buy the property) on a principle residence is considered nonrecourse under Code of Civil Procedure (CCP) section 580b.  When a borrower loses a home in a foreclosure and has a nonrecourse loan, there is a single calculation to determine gain or loss.  If the loan had been refinanced it became a recourse loan because the loan was no longer a purchase money mortgage.  That means that in a foreclosure or short sale the calculation becomes a two-step process as described above.  First there is a calculation of COD income that is the difference between the amount of the loan and the fair market value of the property.  Frequently this has been a substantial amount because real estate values had a significant decrease in recent years.

Example – Short sale in 2010.  Ricky & Lucy purchased a home in San Luis Obispo, California in 1975 for $100,000.  They paid off their mortgage in 2005.  In 2006 they refinanced their home when it was worth $800,000 and took out cash of $600,000 to put their son in music school.   The new loan was interest only.   In 2010 the value of the home had dropped to $400,000 and they sold the home in a short sale.

Because their loan at the time of the short sale was not a purchase money mortgage it was a recourse loan.  Their COD income was $200,000 (Loan balance $600,000 minus Fair Market Value $400,000 = $200,000).  A second calculation of gain or loss is then done.   Their gain on the sale of the home is $300,000 (Fair Market Value $400,000 minus Cost of $100,000 = $300,000).  Ricky & Lucy can exclude up to $500,000 of gain on the sale of their primary residence.  But the COD income cannot be excluded under the primary residence rules.

Effective January 1, 2011 the California statute was revised to include a new section that provided a significant benefit for California individuals selling their homes in short sales.  The new CCP section 580e treats short sales in the same manner as purchase money mortgages.  Borrowers are not personally liable for any amount of a loan beyond what is paid to the lender in the sale when the lender agrees to a short sale.

The IRS and FTB issued recent guidance on the interpretation of CCP 580e.  In the guidance both the IRS and FTB agree that a California resident selling their home in a short sale will be treated as having nonrecourse debt.  With nonrecourse debt there is no COD income.  This is substantially different than what had been understood in the past.

Example – Short sale in 2012.  Ricky & Lucy purchased a home in San Luis Obispo, California in 1975 for $100,000.  They paid off their mortgage in 2005.  In 2006 they refinanced their home when it was worth $800,000 and took out cash of $600,000 to put their son in music school.   The new loan was interest only.   In 2012 the value had dropped to $400,000 and they sold the home in a short sale. 

They do not have any COD income!  Because the property was sold in a short sale the loan is treated as nonrecourse.  Their gain is $500,000 ($600,000 loan balance minus Cost of $100,000 = $500,000).  Because the home was their primary residence, Ricky & Lucy can exclude the entire $500,000 gain.

The guidance was released by the IRS and FTB at the end of 2013 – long after most people with short sales had already filed tax returns for 2011 & 2012.  Those returns can be amended to correctly report the short sales and recoup any taxes paid (or reduce or eliminate any balances still unpaid).

If you have any questions about COD income or the recent guidance on California short sales, contact one of the tax professionals at Seid & Company, CPAs.