Normally, the cancellation of debt is a taxable event. This means that if a creditor forgives a debt, or accepts less than what is owed to them, they issue a 1099 and the Internal Revenue Service and Franchise Tax Board in California will consider the forgiven debt as income. Forgiven debt is considered income because you owed a certain amount, and now you don't have to pay it back, so you received a benefit from it.
In the current real estate crisis, more and more consumers have their homes foreclosed on them, or they have to do a short-sale due to their financial situation. It would add insult to injury if they have to pay taxes on a second mortgage or a home equity line for a home they no longer own. Because of this, the federal and state governments have enacted laws that protect the homeowner from this situation.
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For federal taxes, there is the Mortgage Forgiveness Debt Relief Act of 2007. This law excludes debts forgiven from 2007 to 2012 on a consumer's primary residence if their principal balance was $2 million or less. If you are married and filing separately, the exclusion is only up to $1 million. One limitation of this act is that it only applies to the amount used to buy, build, or substantially improve a primary residence. If debt was forgiven and it was used to pay off your debts, or buy another car, those amounts are not subject to the exclusion. If you had refinanced your home, only the amount of the old principal balance is subject to the exclusion, not the new refinanced amount. Debt forgiven on rental properties, second homes, and other types of property are still subject to taxes if the debt is forgiven, unless other tax relief is available.
California has also followed suit to provide some debt relief for residents of California. California enacted SB 401, Mortgage Forgiveness Debt Relief, to aid homeowners that had their houses foreclosed, went through a short-sale, or had their loan modified from 2007 to 2012. It excludes canceled mortgage debt up to $500,000 of the consumer's principal balance on their primary mortgage. Married couples or domestic partners filing taxes separately can only exclude up to $250,000. Similar to the federal Mortgage Forgiveness Debt Relief Act, this only applies to primary residences. Second homes, rental property, and business property do not receive the same tax exclusions.
If it is a second home, rental property, or business property that was foreclosed or sold short, it is highly advisable that seek the advice of a professional.
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