Short Sale Tax “Fix” Could Create a New Financial Crisis

Real estate investors looking to help homeowners shed their debts – and their homes – via short sale should beware California’s “tax fix” for upside down property owners who sell their homes via the now-classic method of working with the bank to get the loan forgiven for less than is owed, given that the seller is no longer the owner of the house.

As tax season looms, homeowners who did the right – but painful – thing and worked out an agreement with their banks or lenders to forgive a portion of the debt via short sale are finding that their financial crisis resolution may have created a tax debt for tens of thousands of dollars. How? Because the governor of California vetoed a bill containing protective legislation that would prevent that forgiven debt from being considered taxable income.

Turns out, the real issue with the legislation has nothing to do with short sales. Instead, Governor Schwarzenegger vetoed the bill because it contains penalties for filing unfounded tax refund claims, but those penalties are restricted to high-income filers. Basically, the bill contains language that says unless you make a lot of money, you can make unfounded tax refund claims. Earn too much and mess up your return, though, and you are on the hook with the IRS. Governor Schwarzenegger doesn’t think it’s fair and refuses to sign this type of legislation.

However, political leanings aside, this gridlock between the governor and the legislature is really hurting homeowners who did short sale transactions in 2009 and it could continue in this state until the governor and the legislature manage to “duke it out.” The governor refuses to sign tax bills with the problematic income tax refund language, and the legislature refuses to send a bill without it. The stalemate really does start to look a little suspect when you note that then-President George W. Bush signed nearly identical legislation in 2005 that simply stated that unfounded tax refund claims could be punished, regardless of your income. It looks like the legislature just doesn’t want to lose the taxable income on the short sales from a skeptic’s point of view.

But ultimately, how you feel about the legislation in question is not the point. The taxable income of hundreds of thousands of dollars in forgiven debt is the issue at hand for short sale negotiators and real estate investors. Short sale transactions can enable you to purchase a home for pennies on the dollar in many cases, but at least in California, someone is going to have to pay the piper even if the lender forgives the debt. So if you are involved in short sales, check the tax ramifications for both you and your buyer before you sign on the line. You do not want to create a new crisis instead of solve one.

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