Tax avoidance for discounted shortpays set to expire – are Californians in trouble?

In response to the housing crisis, the federal Mortgage Forgiveness Debt Relief Act (the Act) expanded tax relief for lender discounts on shortsales to cover both recourse and nonrecourse mortgages. If the Act is allowed to expire at the end of 2012, many California homeowners with underwater homes will lose their ability to avoid income taxes on the resulting discharge-of-indebtedness income.

In the fourth quarter of 2011 there were over two million mortgages with negative equity in California. Thus, about a third of all California homeowners were encumbered by a mortgage amount exceeding the value of their home, according to Corelogic. With shortsale negotiations still taking in excess of five months, homeowners looking to escape from their underwater prisons had better get a move on or find out whether they are covered by some other regulation before the Act expires.

With an annual price tag of $1.35 billion in lost tax revenue, Congressional members of the austerity camp counting down to Re-Election Day will fight hard to keep the Act from being renewed. How else to better prove they’re tough on homeowners who “unfairly” receive forgiveness for their housing debts while others continue to pay?

Say Congress does forget what their institution is about (likely) and allows the Act to expire. Fortunately, dear reader, there is recourse available for most shortsale-prone Californians – or should we say nonrecourse?

The back-up escape route to the Act’s expiration lies in federal regulations. To understand the regulations, a review of California anti-deficiency statutes is needed.The anti-deficiency statutes bar a mortgage lender from collecting any market-driven loss on a purchase-assist loan encumbering a one-to-four unit principal residence. Such a home loan is considered a nonrecourse loan since the buyer is never personally liable for the loan, and the lender’s sole source of recovery is the home securing the purchase-assist loan.

A homeowner with a nonrecourse loan who participates in a shortsale, foreclosure or principal reduction incurs no discharge-of-indebtedness income since any windfall on nonrecourse loans in a shortsale is not reported as taxable income. This regulation is not contingent on the Act, and in fact has been around since the 1930s.

If the Act is not renewed, an increase in strategic defaults is the likely result, especially among homeowners with recourse mortgages not covered by the Internal Revenue Service (IRS) regulations for nonrecourse loan shortpay on a shortsale. Underwater homeowners with recourse loans will simply skip the rigmarole of wrangling with a lender for shortsale approval and abandon their attempt to “do good” by selling the property to help satisfy the lender.

Instead, they will be compelled to simply walk away from their properties, properly seeing no benefit for being taxed on the “gain” from the debt forgiven in a shortsale.

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