Recently I met with an individual who was concerned about the tax implications between a foreclosure vs. doing a short sale – and the potential of having to pay taxes on the short sale. I believe this individual felt there would be no (or maybe less) tax implications if the property were simply to go through the foreclosure process.

The first thing I said was I’m not a tax attorney or CPA so I can’t give tax advice, and all tax implications must be discussed with your tax adviser. But having said that, here are the general federal and California rules, forms, etc, pertaining to this issue. A foreclosure or short sale results in the cancellation of debt. When a mortgage debt is settled for less than the amount due, the lender will send a 1099-C. Normally, that amount is taxable income.

The first issue is what kind of debt? Recourse or non-recourse? Non-recourse is the kind of debt whereby the lender can’t come back to you if they lose money on their loan. Purchase money loans in California are non-recourse debt. Re-finances and lines of credit aren’t purchase money loans so they are recourse loans.

Cancellation of debt on purchase money loans on a “qualified principal residence” are exempt from federal income tax per the Mortgage Debt Relief Act of 2007. It makes no difference if the 1099-C generated was through foreclosure or a short sale. This law is good through 2012 (maybe it will be extended?). The homeowner will complete IRS form 982.

Re-finances and lines of credit (recourse debt) are more tricky. The IRS says “debt used to refinance your home qualifies for this exclusion, but only to the extent that the principal balance of the old mortgage, immediately before the refinancing, would have qualified”. So money above that amount might be subject to taxation unless the insolvency or bankruptcy exemptions apply.

As far as California taxation goes, it generally follows the federal rules. However, California has smaller limits than the fed. As always, get specific tax counsel from your tax adviser.  I found this recent and detailed article from Inman News to be helpful.

One final note: this article deals only with cancellation of debt issues and not capital gains tax. Most short sale/foreclosure properties don’t have capital gains issues because they were bought for substantially more than their current worth. Capital gains might be involved if the property was owned for a long period of time and then re-financed, pulling cash out.

Finally, here are some official IRS links:

The Mortgage Forgiveness Debt Relief Act and Debt Cancellation

IRS Publication 4681