When a property owner is unable to make the payments on his or her mortgage, one obvious solution is to sell the property. But what if the value of the property is less than the amount of the mortgage? In that case, a sale is not possible, unless the lender consents to a “short sale,” meaning a sale of the property for less than the amount of the debt which is secured against it.

On first sight, short sales sound like a win-win proposition for all involved. For the property owner, it permits them to get out of a debt that they can not pay, without a foreclosure. For the lender, it permits them to get as much value as possible, without going through the whole foreclosure-REO re-sale process. As a practical matter, the owner of the home is often able to sell it for far more than the REO Department of a bank. And short sales can be a win for brokers, because they permit sales to occur, in a market in which very few houses are being sold, at any price.

Is the property owner still liable on the debt after a short sale?

Homeowners ordinarily cannot be liable for a deficiency judgment, due to two statutes: Code of Civil Procedure 580b and Code of Civil Procedure 580d. CCP 580b provides that no deficiency judgments can be obtained after foreclosure sales on purchase money loans secured against residential property with one to four units. CCP 580d provides that no deficiency judgment can be obtained in any non-judicial foreclosure. Taken together, these two statutes make deficiency judgments unobtainable in virtually all foreclosures against homeowners. But neither of these statutes applies to a short sale, because no foreclosure takes place in a short sale. Thus, until shortly, a property owner who agreed to a short sale could be sued by the lender for a deficiency, unless the lender agreed to waive the deficiency.

In 2010, the Legislature gave us a partial fix to this problem. It enacted new CCP Section 580e, which provides that if the first trust deed or mortgage holder agrees in writing to accept a sale, which pays it less than the full amount it is owed, it cannot pursue the borrower for the rest of the loan. The law has several exceptions.

First, it applies only to first trust deeds or mortgages. It does not apply to junior deeds of trust or mortgages, which can still pursue the borrower after a short sale for any shortfall.

Second, it applies only to dwellings with less than four residential units. It does not apply to commercial properties or apartment buildings.

Third, the lender is expressly permitted to sue the property owner for fraud in the short sale process or waste, i.e. causing damage to the property.

Does the home owner owe income taxes on the written-off debt?

If the lender agrees to a short sale, and agrees that it waives the rest of the mortgage, this creates another problem for the property owner. Since the lender has agreed to wipe out a certain amount of debt, under ordinary Internal Revenue Service rules, the property owner has just increased his or her income by the amount of debt which has been forgiven. Under ordinary rules, the property owner has to pay federal and state income tax upon this forgiveness of debt income. This result is underlined, since, after a work-out, the lender is required to give the property owner a 1099-C form reflecting cancellation of debt income for federal tax purposes.

Fortunately, the federal portion of this problem has been solved, at least until January 1, 2013. On December 20, 2007, President Bush signed into law H.R. 3648, the Mortgage Forgiveness Debt Relief Act of 2007. It provided that forgiveness of debt income is NOT income for purposes of paying federal income taxes as to “qualified principal residence indebtness” which was forgiven prior to January 1, 2010. The deadline in the law was subsequently extended to January 1, 2013.

“Qualified principal residence indebtedness” is defined by 26 U.S.C. Section 108(h)(2) as meaning the same thing as 26 U.S.C. Section 163(h)(3)(b), with upper adjustments in the amounts. In plain English, this means debt which was incurred in purchasing, building or substantially improving a residence, as long as the debt is secured against the residence. The amount involved can not exceed $2 million, or $1 million for a married taxpayer filing separately.

What about California state income taxes? California has passed no equivalent to the federal Mortgage Forgiveness Debt Relief Act. However, Revenue & Taxation Code Section 17131 provides that, unless there is some specific California statute to the contrary, California law tracks federal law on what income is excluded from taxation. Since there is no specific California law on this issue, short sales ordinarily do not produce taxable income under California law either, at least as long as the federal law so provides.

Two caveats should be noted, however.

First, the new law is only good through January 1, 2013. It might be renewed, but it has not been yet.

Second, while forgiveness of debt in a short sale does not equal taxable income, under Internal Revenue Code Section 108, such debt forgiveness still has negative tax consequences. The law provides that, while the amount forgiven is not taxable income, the taxpayer has to give up tax advantages of other types, to compensate for this. If the taxpayer owns other properties, his or her basis in those properties has to reduced, which increases the amount of capital gains taxes he or she may have to pay upon sale of the other properties. Or, if the taxpayer, has Net Operating Losses, which reduce taxable income, these NOLs may have to reduced. In short, the taxpayer does not get off without any pain. If you are in this situation, you should consult with a Certified Public Accountant about how it affects your taxes.