Tax implications of a short sale? In California, maybe — for now.

A condo full of freelancers?
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I occasionally troll “Trulia Voices,” Trulia.com’s question and answer forum.  Usually, I end up averting my eyes. It goes something like this. Buyer or seller asks question; seventy-three agents respond, like someone fired the starting gun for the final heat, with all sorts of helpful advice and offers for their services.

I tend to avert my eyes because, so often, ethical and even legal lines are blurred.  Agents start blathering about their commissions in real numbers (an anti-trust no-no in a public forum), or dispensing legal advice absent a law degree. Recently a relatively benign consumer question about discounted fees resulted in an ugly food fight with agents talking smack about and to each other concerning their particular business models. And in cases like this, all I can think is, “Dudes! This isn’t a private water cooler. General Counsel is listening.” Or, in the words of Hill Street Blues‘ Sgt. Esterhaus, “Let’s be careful out there.”

This week I came across this question on Trulia from a San Diego homebuyer:

My husband and I opened escrow on an approved short sale a week ago. Today, our agent called the listing agent to confirm the appointments for the home inspector and the appraiser. The listing agent said he needed to call the seller to confirm, but when the listing agent called back, he said that we needed to hold off on the appraisal and inspection because the seller wants to see if the new California legislation regarding debt cancellation will be signed into law by the governor. If it’s not, the seller says he can’t (or won’t) short sale the property. We had our offer on this home accepted in January, waited 2 months for approval, and have been in escrow for a week. Can the seller cancel???? What recourse do we have????

My first reaction, of course, was to wonder why they are using their “Ask the Audience” chit rather than phoning a friend – say, their agent… or a real estate attorney – but it does raise an interesting, contemporary topic.

Now, as a real estate agent who doesn’t hold a Juris Doctorate, I am not at liberty to dispense legal advice, but that doesn’t mean I can’t talk around the issue, and it’s one I’ve been meaning to address here for a few weeks.

What the home buyer is referring to is the possibility of California taxation on forgiven loan debt. The San Diego Union-Tribune reported on this earlier this month:

The tax applies to what is called the “cancellation of debt” that occurs when property owners lose their homes through foreclosure or arranges (sic) a short-sale in which they sell for less than the mortgage balance. The lender sends them a form itemizing the forgiven debt, and the amount is subject to income tax… Congress exempted most homeowners from the extra federal tax through 2012, and the state followed suit for 2007 and 2008 but did not extend the provision last year.

The result is that, in California, there are currently a lot of short sellers who are getting surprise 1099s for the forgiven debt on a short sale and are faced with State tax bills they hadn’t anticipated. Bills are currently in review that would extend the mortgage forgiveness act, but to date there has been no resolution. Even if passed, the Governor could veto.

An important caveat is that this applies only to recourse loans — typically refinances, second mortgages or equity lines. Non-recourse loans in California are not taxable (according to people who are attorneys, which I am not). ALWAYS consult an attorney or or your favorite accountant for the final word.

There is a second issue in the buyer’s situation. Is the seller contractually obligated to sell? That would depend on their contract and whether or not their open escrow came with lender approval letters (upon which our standard Short Sale Addendum says the sale is predicated). Regardless, and keeping in mind that I am not an attorney, even with a valid contract, the buyer’s remedy would be to force the sale by suing for specific performance. Not being an attorney and all (and hoping I have made that really, really clear), my guess is that successfully litigating this, forcing a financially strapped seller who is in a distress sale situation from his home, would be a smidge dicey at best.

But what do I know? I’m not an attorney.

There are actually three morals to this story. First, short sales are a turkey shoot. The process is long and fraught with uncertainty, and there is a higher level of difficulty in ultimately getting that coveted date with the County Recorder.

Second, short sellers with non-recourse financing may be facing a tax event in California. Hopefully, the State will act to address the inconsistencies with Federal law, but for now we are in limbo.

Finally, be careful about advice you get online, particularly from agents attempting to practice law.

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