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Mortgage Forgiveness Debt Relief -
Updated 1.27.2014

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Taxable years 2013 and Later - Tax Relief for Short Sales

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

For federal income tax purposes, mortgage forgiveness debt relief exclusion applies to discharges occurring on or after January 1, 2007, and before December 31, 2013. However, for California purposes, the exclusion applies to discharges occurring on or after January 1, 2007, and before December 31, 2012. California did not enact legislation to extend the exclusion to include the taxable year 2013.

However, there is relief for taxpayers who sell their principal residence in a “short sale.” (“Short sale” refers to a sale of real property 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.
  • Who recognized cancellation of indebtedness income from a short sale in 2011 and 2012.

Capital Gains Income Not Excluded

Even though California taxpayers may not have cancellation of indebtedness income on the short sale of their residences, they may incur capital gains income on the transactions, which could be taxable. Taxpayers are encouraged to refer to IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments and IRS Publication 523, Selling Your Home.

Taxpayers with transactions involving debt cancellation may want to consult with a tax professional.

Non-Judicial Foreclosures

Information can be found in IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments. According to page four of the publication, the following applies to sales and other dispositions (such as foreclosures and repossessions):

  • Nonrecourse debt. If you owned property that was subject to a nonrecourse debt in excess of the FMV of the property, the lender's foreclosure on the property does not result in ordinary income from the cancellation of debt. The entire amount of the nonrecourse debt is treated as an amount realized on the disposition of the property.
  • Recourse debt. If the lender forgives all or part of the amount of the debt in excess of the FMV of the property, the cancellation of the excess debt may result in ordinary income. The ordinary income from the cancellation of debt (the excess of the canceled debt over the FMV of the property) must be included in your gross income reported on your tax return unless one of the exceptions or exclusions applies.

Loan Modifications

According to IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments, loan modifications that involve principal balance reductions of a recourse loan generally result in taxable cancellation of indebtedness income. Page four of the publication states the following with regard to discounts and loan modifications:

  • If a lender discounts (reduces) the principal balance of a loan because you pay it off early, or agrees to a loan modification (a “workout”) that includes a reduction in the principal balance of a loan, the amount of the discount or the amount of principal reduction is canceled debt. However, if the debt is nonrecourse and you did not retain the collateral, you do not have cancellation of the debt income. The amount of the canceled debt must be included in income unless it meets one of the exceptions or exclusions.

Taxable years 2009 through 2012

On April 12, 2010, SB 401, the Conformity Act of 2010 was enacted. It allows taxpayers who had all or part of the loan balance on their principal residence forgiven by their lender to exclude the forgiven debt from California gross income. The new law applies to discharges of qualified principal residence indebtedness on or after January 1, 2009, and before January 1, 2013.

California law conforms, with modifications, to federal mortgage forgiveness debt relief for discharges that occurred in tax years 2007 through December 31, 2012. The amount of qualifying indebtedness is less than the federal amount and California imposes a state-only limitation on the total amount of relief excluded from gross income. The following summarizes the differences between the federal and California provisions. Federal provision applies to discharges occurring in 2007 through 2012, and:

  • Limits the amount of qualified principal residence indebtedness to $2,000,000 for taxpayers who file as married filing jointly, single, head of household, or widow/widower, and to $1,000,000 for taxpayers who file as married filing separately.
  • Does not limit the debt relief amount; it only limits the indebtedness amount used to calculate the debt relief amount.
  • See the federal law Mortgage Forgiveness Debt Relief Act and Debt Cancellation for more information.

California provision applies to discharges that occurred in 2007 through 2012, and:

Taxable years 2009 through 2012

  • Limits the amount of qualified principal residence indebtedness to $800,000 for taxpayers who file as married/registered domestic partners (RDP) filing jointly, single, head of household, or widow/widower, and to $400,000 for taxpayers who file as married/RDP filing separately.
  • Limits debt relief to $500,000 for taxpayers who file as married/RDP filing jointly, single, head of household, or widow/widower, and to $250,000 for taxpayers who file as married/RDP filing separately.

Taxable years 2007 and 2008

  • Limited the amount of qualified principal residence indebtedness to $800,000 for taxpayers who file as married/(RDP) filing jointly, single, head of household, or widow/widower, and to $400,000 for taxpayers who file as married/RDP filing separately.
  • Limited debt relief to $250,000 for taxpayers who file as married/RDP filing jointly, single, head of household, or widow/widower, and to $125,000 for taxpayers who file as married/RDP filing separately.

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.

Form 540X - Claiming mortgage forgiveness debt relief for a previously-filed tax return

If you already filed your tax return, file a Form 540X, Amended Individual Income Tax Return, in order to claim debt relief.

If the amount of debt relief for federal purposes is the same as or less than the California limit(s), an adjustment to income is no longer necessary on Schedule CA (540/540NR). On Form 540X, simply enter on line 2e, column B, the amount originally entered on Schedule CA (540/540NR) line 21f, column C.

If the amount of debt relief for federal purposes is more than the California limit(s), complete a new Schedule CA (540/540NR) and revise the amount originally reported on line 21f, column C, attributed to federal mortgage forgiveness debt relief, to the amount in excess of the California limit. Complete Form 540X following the instructions for that form and enter on line 2e, column B the difference from the original Schedule CA (540/540NR), line 21f, column C, less the amount from the revised Schedule CA (540 or 540NR), line 21f, column C.

When filing Form 540X, write "Mortgage Debt Relief" in red across the top of your amended tax return.

Cancellation of Debt

Generally, if you have property that is used as security for a debt and that property is taken by the lender (foreclosed) in full or partial satisfaction of the debt, you are treated as having sold the property.1 This may generate either a gain or a loss, and in some cases cancellation of debt (COD) income. A mortgage restructuring (such as reduction in principal), that reduced your debt may also generate COD income.

In the wake of the 2007 American housing market collapse and subsequent mortgage crisis, the U.S. Congress enacted the Mortgage Forgiveness Debt Relief Act of 2007 (P.L. 110 142) and Emergency Economic Stabilization Act of 2008 (P.L. 110-343).

These Acts include provisions under federal law that, subject to certain conditions, that allows taxpayers to exclude from their federal taxable income the discharge of debt on their principal residence (COD income) that they would otherwise have been required to report (2007 through 2012).2 The special federal rules relating to qualified principal residence apply to debt reduced through mortgage restructuring, as well as to mortgage debt forgiven in connection with a foreclosure.

Property other than principal residence

The federal Mortgage Forgiveness Debt Relief Act only provides for the exclusion of COD income relating to qualified principal residence. If you have COD income as the result of a foreclosure on other property, such as a second (vacation) home, rental, or other business property, you may still be able to exclude COD income under other provisions if:

  1. You were bankrupt when the discharge occurred (Title 11 discharge).
  2. You were insolvent (limited to level of insolvency).
  3. Qualified farm indebtedness was canceled.
  4. Debt was Qualified Real Property Business Indebtedness (QRPBI)3 and you make a federal election.

If more than one of these exceptions applies, they are applied in the above order.4

For more information, see IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments. The IRS Publication 4681 has a worksheet that can be used to help calculate the extent to which a taxpayer is insolvent immediately before the cancellation.

Information resources


1Refer to the February 2010 Tax News article California Code of Civil Procedures and Foreclosure for more information regarding how California Civil Procedure Code (CCP) Sections interact with IRC Section 108.

2Federal law initially applied to discharges occurring from 2007 through 2009 (the Mortgage Forgiveness Debt Relief Act of 2007, Public Law 110-142, December 20, 2007). Federal mortgage forgiveness debt relief was subsequently extended to apply to discharges occurring from 2009 through 2012 (the Emergency Economic Stabilization Act of 2008, Public Law 111-5, October 3, 2008).

3The taxpayer cannot be a C corporation to use this exclusion.

4IRC section 108(a)(2).