Tax Relief on Short Sales Expires in December ...

... unless, of course, Congress and our state legislature both take action.  Here's the situation as summarized recently by the California Association of Realtors in a recent newsletter:

Tax relief on forgiven debt set to expire Dec. 31, 2012
Unless Congress and the California State legislature take action, a break for mortgage principal forgiven in loan modifications or short sales will expire at year’s end.

The mortgage debt forgiveness issue is only one of approximately 60 expiring tax provisions that Congress appears unable to extend prior to its recess for the November elections.  Congress is pushing the extension of any expiring tax provision to the lame duck session, along with any increase in the debt ceiling, and any serious attempts to prevent the mandatory budget cuts agreed to during last year’s debt ceiling deal.

California's tax treatment of mortgage debt relief income generally aligns with federal law, and both the California and federal laws are set to expire at the end of 2012. For debt forgiven on a loan secured by a "qualified principal residence," borrowers are exempt from both federal and state income tax consequences, but only until Dec. 31, 2012.  The existing federal exemption is for indebtedness up to $2 million, whereas the new California exemption is for indebtedness up to $800,000 and forgiven debt up to $500,000.

"Qualified principal residence" indebtedness is defined as debt incurred in acquiring, constructing, or substantially improving a principal residence.  It includes both first and second trust deeds.  It also includes a refinance loan to the extent the funds were used to pay off a previous loan that would have qualified.

However, these tax breaks apply only to debts discharged from 2009 through 2012. It may be that Congress will take action to extend the federal exemption before year-end, but we will have to wait and see. If the federal law is extended, it is likely that California would follow in due course, as in the past, but it is not guaranteed.  The last time the federal tax exemption was extended, California did not conform its tax law until well into the next year.

Sellers who have transactions closing after Dec. 31, 2012, need to speak to their own legal counsel or tax advisors about the impact of the expiration of these laws and their potential tax liabilities, including the applicability of other exemptions from debt relief income tax.