by Calculated Risk on 11/17/2013 11:19:00 AM

From Nick Timiraos at the WSJ: Why California Homeowners Could Avoid a Tax Hit (ht picosec)

The tax provision currently allows some homeowners—mostly those facing foreclosure—to avoid paying taxes on certain relief that they receive on their mortgages. The IRS considers debt forgiveness to be a form of taxable income. That means homeowners who sell their homes for less than the amount they owe in a short sale could face a tax bill.

In 2007, as the foreclosure crisis spread, Congress exempted some homeowners from counting certain kinds of forgiven mortgage debt as taxable income in order to encourage banks and borrowers to seek foreclosure alternatives. Congress retroactively extended the provision earlier this year, after it expired on Dec. 31, 2012. The provision is set to expire this coming Dec. 31 and there appears to be less urgency in Congress right now to pass an extension.

In the letter to Sen. Boxer, the IRS clarified that certain non-recourse debt forgiven by lenders wouldn’t typically be considered taxable income by the IRS. This means that for most California borrowers, the expiration of the tax provision may not have a meaningful effect.

The key section in the IRS letter is:

"[I]f a property owner cannot be held personally liable for the difference between the loan balance and the sales price, we would consider the obligation as a nonrecourse obligation. In this situation, the owner would not treat the cancelled debt as income."

Since California (and other states) passed anti-deficiency provisions, this means many loans will be considered nonrecourse by the IRS.

The number of short sales is already declining rapidly, and I was expecting short sales to fall off a cliff in January 2014. This letter suggests short sales will continue in certain states (the letter is only for California, but other states have similar statutes).