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Short Sale Tax Relief in California

taxhome_tnFor tax years 2013 and later, California did not enact legislation to conform to the 2013 extension of the federal Mortgage Forgiveness Debt Relief Act and Debt Cancellation.

However, there is short sale tax relief for taxpayers who sell their principal residence for less than the outstanding mortgage loan balance with consent of the lender).

California conforms to federal law and according to the IRS Information Letter dated September 19, 2013, the IRS has determined that California taxpayers who sell their principal residences where the lender has agreed to a short sale for less than what is owed on the home do not have cancellation of indebtedness income, which may have been taxable. Instead, the amount of cancelled debt is included in the amount realized in determining gain on the sale of that residence.

The IRS guidance is limited to short sales only involving a principal residence for tax years 2011 and forward. The IRS guidance did not specifically address other types of real estate transactions such as non-judicial foreclosures.

This guidance is relevant to California taxpayers:

  • Who incurred short sales in 2013 since California’s Mortgage Debt Relief Act expired at the end of 2012.
  • Who recognized cancellation of indebtedness income from a short sale in 2011 and 2012.

How to File

Form 540 – Claiming mortgage forgiveness debt relief on an original tax return

You can file for debt relief on your original Form 540, California Resident Income Tax Return, or Form 540NR, California Nonresident or Part-Year Resident Income Tax Return.

If the amount of debt relief for federal purposes is the same as or less than the California limit, then no adjustment is necessary on Schedule CA (540/540NR).

If the amount of debt relief for federal purposes is more than the California limit, include the amount in excess of the California limit on Schedule CA (540/540NR) line 21f, column C.

You must include a copy of your federal return, including Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), with your original California tax return. There is no similar California form.

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