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They finally passed it. Distressed homeowners no longer have to pay California state income tax on debt forgiven in a short sale, foreclosure or a loan modification. It was just signed into law on Monday. This puts the State in line with the Federal law. For debt forgiven on a loan secured by a “qualified principal residence” borrowers will now be exempt from both federal and state income tax consquences. The existing federal exemption is for indebtedness up to $2 million, where the new California exemption is for indebtedness up to $800,000 and forgiven debt up to $500,000.
“Qualified principal residence” indebtedness is defined as debt incured in acquiring, construction, or substantially improving a principal residence. It includes both first and second trust deeds. It also includes a refinance loan to the extent the funds were used to payoff a previous loan that would have qualified.
The tax breaks apply to debts discharged from 2009 to 2012. Californias who have already filed their 2009 tax return may claim the exemption by filing a Form 540X amendment.
Taxpayers who do not qualify for the above exemptions (for example a second home or rental property) may nevertheless be exempt under other provisions. Most notably, taxpayers who are bankrupt are exempt from debt relief income tax. Also, taxpayers who are insolvent are exempt from debt relief income tax to the extent their current liablities exceed current assets.
For more information go to California Franchise Tax board Mortgage Forgiveness Debt Relief Extended webpage and the Internal Revenue’s Mortgage Forgiveness Debt Relief Act and Debt Cancellation web page.
Of course each person’s tax issues are different so check with your tax preparer to see what applies to your specific case.