California won’t tax forgiven home debt

Governor Schwarzenegger on Monday signed SB 401 (Wolk) into law providing distressed homeowners with state tax exemption on debt forgiven in a short sale, foreclosure, or loan modification.

MAKING SENSE OF THE STORY FOR CONSUMERS:

SB 401 generally aligns California's treatment of taxes on forgiven mortgage debt with that of federal law. For debt forgiven on a loan secured by a "qualified principal residence," borrowers now will be exempt from both federal and state income tax consequences. Previously, California homeowners generally were exempt from owing federal taxes on the forgiven mortgage debt, but still were required to pay California taxes on the so-called "phantom income."

- Qualified principal residence indebtedness is defined as debt incurred in acquiring, constructing, or substantially improving a principal residence, including both first and second mortgages. It also includes refinance loans to the extent the funds were used to payoff a previous loan that would have qualified under these guidelines.


- The tax relief applies to debts discharged from 2009 through 2012. Californians who already have filed their 2009 tax returns may claim the exemption by filing a Form 540X amendment.


- Taxpayers who do not qualify for the above exemptions (e.g., second home or rental property) still may be exempt from paying taxes on forgiven mortgage debt under other provisions. Most notably, bankrupt taxpayers are exempt from debt relief income tax. Also, taxpayers who are insolvent are exempt from debt relief income tax to the extent their current liabilities exceed current assets.